Best exams techniques

This is what it all comes down to; you’re sitting in the exam hall, waiting to get your hands on that
anticipated piece of paper. You’ve jammed a ton of information into your brain and your fingernails are
non-existent – it’s time to get down to business!

Yes the exam environment may be different across disciplines. Computing students will sit some tests
in front of a computer with their fingers poised to code. A practical element will contribute to science
student’s final grade. It doesn’t matter if you’re studying English, Economics, Psychology or History,
every exam can be approached in much the same way with these exam writing tips.

We’re here to give you some help answering and writing exam questions that will show your knowledge
to the person who reads your paper.

How to Answer Exam Questions

Pay attention! These quick tips should be common sense but many students who are under exam
stress fail to see their mistakes. We’re going to help you avoid a major exam disaster by pointing you
in the right direction.

Here’s our top exam writing tips to help you understand how to answer exam questions:

1. Practice Past Papers

First of all don’t confuse the method or the words changing on any kind of question. Pick the main
theme and objective of the question and forget related question wording. In this point mostly student
get confused about the answer which is in there mind. There really is no better way to get exam ready
than by attempting past papers. Most exam bodies should have past papers available online but your
teacher will get you started on these in class.

This process isn’t just about preparing an answer for a specific question, it’s about understanding how
you approach a question in an exam, how to structure your answer, the timings you should assign and
what information will get marks.

If you want to create an easy way to test yourself with past papers and feeling some psychological
issues about your mental level then try the to concern Kashaan Academy for taking some useful
guidance regarding your exams:

2. Read All Questions Carefully

The stress of the situation can cause you to misread a question, plan your answer out, start writing
your response and then realize you made a mistake and wasted vital time. Even though you generally

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won’t be writing answers to every question on the paper, reading all questions thoroughly will ensure
you make the right choices and can highlight how much you know about the topic.

Don’t forget to attempt all questions that you have selected. However, be careful of MCQ questions
with negative marking. If you’re not sure of the answer you could cost yourself some valuable marks.

3. Manage Your Time

This is where you need to be strict on yourself. Once you have assigned a time limit for each question,
you MUST move on once you hit it or you won’t be able to give the next question your full attention.

Remember to leave yourself some time at the end to go back over your answers and add in little notes
or pieces of information about the topic. You never know, this could help bump you up a grade!

4. Structure Your Answer

Write to maintain heading and points in your answer. In this style of writing your question getting
perfect and looking good. As you give heading to your answer your opinion and vocabulary getting
sharp and sharp in your mind.

Exam Writing Tips Don’t just jump into writing your answer. Take the first few minutes to plan the
structure of your essay which will save you time when you are delving into meaty parts. Always stay
on topic; if you’re discussing the role of women in society as portrayed by the author in Of Mice and
Men, don’t digress and start outlining other themes in the book for example. Most essays should have
an introduction, three main points and a conclusion. A lot of students see a conclusion as a final
sentence to finish the piece off. A strong conclusion give an A grade student the chance to shine by
bringing everything together and fortifying their opinion.

5. Explore Both Sides of an Argument

Building your argument in the main body of your exam answer will give your overall opinion credibility.
English language questions, for example, encourage you to explore both sides of an argument and
then conclude with a critical analysis of your answer.

Many questions you approach will look as though they seek a straightforward answer but in reality they
want you to fully outline a structured essay. Don’t fall into the trap of providing a one-sided view, get
your hands dirty and open your mind to other possibilities.

6. Review Your Answers Thoroughly

Smart students can still make the mistake of handing their answer book in without checking through
what they have written. Proofread your answers as much as you can to correct any spelling mistakes
and add any extra comments you think are worth mentioning. You will be surprised what you can spot
in those last few minutes. This is your last chance to throw in that quotation, list other relevant points
or even draw a quick diagram. Now is not the time to drop your game, show the examiner what you’re
made of!

Remember, the exams are not designed to trick you. Don’t panic on the day of your exam or this brain
freeze could mean that you get a lower grade that you truly deserve. Convince yourself that you know
how to answer exam questions and your almost there.

Let’s start to prepare your exams. We hope

you will find out a better Student Regarding
your study and exams, Kashaan Academy
wishes for you and to all the best for your
exams and upcoming life.
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 Solved guess paper
Introduction to Microeconomics (801) M.Sc Economics
Q.1 Explain the main criteria for classifying firms into industries. Which criteria serve the
better and why? (20)

A leading, industrially advanced developing country, India has large, medium and small i n d u s t r i a l
units of production in almost all branches of the industry. Since the time of the
independence in 1947, a significant feature of the Indian economy has been the rapid growth of the
small industry sector. The small industry sector is considered to have a major role in the
Indian economy due to its 40 percent share in the national industrial output along with an
80 percent share in industrial employment and nearly 35 percent share in exports. The
small scale industries sector has been assigned an important role in the industrialization of the
country by the previous and current governments of India. There are no clear official definitions of
small scale industry. Small scale industries are usually distinguished from the large-scale and
medium-scale industries on the basis of size, capital resources and labor force in the
units.

Classification of industries based

Basic industries:

B as i c i n du s t r i e s ar e t h os e in du s t ri es wh i c h pr ov i de e s s e n t i al i n pu t s f or t h e
development of other industries and the economy. In other words, these are industries
which provide bases for development of other industries. For example, the iron and steel industry
forms a basis for the development of the engineering industry. Fertilizer is regarded as
basic input for the agriculture. Coal, oil and electricity are also regarded as basic industries
because growth of modern industry depends on the supply of these vital inputs.

Capital goods industries: Capital goods industries are those industries which produce machinery,
equipment or tools. A capital good is one which is instrumental in producing other goods or services.
The capital goods do not directly serve any consumption requirement. They are used
to produce consumer goods (and other goods) and services. The capital goods industries are capital
intensive in nature, i.e., they require heavy capital investment. H a n d t o o l s a n d m a c h i n e t o o l s ,
s p e c i a l i z e d e q u i p m e n t s , E l e c t r i c M o t o r s , H e a v y Vehicles etc.

Intermediate goods industries: I n t e r m e d i a t e g o o d s a r e g o o d s w h i c h h a v e a l r e a d y

u n d e r g o n e m a n u f a c t u r i n g process but which form inputs for other industries as material for
further processing, parrot component .e.g. Cotton Spinning, Tyers & Tubes, Manmade fibers, Bolts,
nuts, screws, spring Metallic

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Consumer goods industries: The consumer goods industries are those industries the output of
which serves the final consumption requirements. The consumer goods may be broadly
classified into C o n s u m e r D u r a b l e s a n d C o n s u m e r N o n - d u r a b l e s . C o n s u m e r n o n -
durables are those goods which are used up at once or within a relatively short
period, like food stuffs, cigarette, soap, electric bulb, etc. onsumer durables,
o n t h e o t h e r h a n d , s e r v e t h e consumers over a relatively long period, like car, bicycle,
electric fan, television, refrigerate, etc. A distinguishing characteristic of the consumer durables is
that their life or service may be extended by repairs.
Criterion/
Abbreviation Full name Sponsor Node count by level Issued
Unit
International
Standard
Industrial United Nations production/ 4 digits 1948–present
ISIC
Classification Statistics Division establishment 21/88/238/419 (Rev. 4, 2008)
of All Economic
Activities
North
American Statistical bureaus 6 digits
production/ 1997, 2002,
NAICS Industry of US, Canada, and 17/99/313/724/1175
establishment 1 (2012)
Classification Mexico (/19745)
System
Statistical
Classification
of Economic European production/
NACE 6 digits
Activities in the Community establishment
European
Community
Australian and
New Zealand
ANZSIC Standard
Industrial
Classification
1937–1987
(superseded
Standard
production/ 4 digits by NAICS, but
SIC Industrial US
establishment 1004 categories still used in
Classification
some
applications)
Industry
market/
ICB Classification FTSE 10/20/41/114[2]
company
Benchmark
Global Industry Standard & Poor's,
market/ 2-8 digits
GICS Classification Morgan Stanley
company 10/24/68/154
Standard Capital International
Thomson
Reuters market/
TRBC Thomson Reuters 10/25/52/124[2]
Business company
Classification
companies/
regions/
Dow Jones
news
DJII Intelligent Dow Jones & Co. 1999
subjects/
Indexing[3]
industries/
people

Classification Based On Process On Product

Primary industry: These extract raw materials, which are natural products untreated by people,
from the land or sea. Mining quarrying, forestry, farming and fishing.
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Cottage industry: Cottage industry (also called the Domestic system) is an industry – primarily
manufacturing – which includes many producers, working from their homes, ty pically part
time. The term originally referred to home workers who were engaged in a task such as sewing, lace-
making or household manufacturing. The business operators would travel around, buying raw
materials, delivering it to p e o p l e w h o w o u l d w o r k o n t h e m , a n d t h e n c o l l e c t i n g t h e
f i n i s h e d g o o d s t o s e l l , o r typically to ship to another market. Cottage industries were very
common in the time when a large proportion of the population was engaged in agriculture,
because the farmers (and their families) often had both the time and the desire to earn additional
income during the part of the year (Winter)when there was little farming work to do.

Tiny industries: Government have already announced increase in the investment limits in
plantand machinery of small scale industries, ancillary units and export – oriented units to Rs6
million, Rs 7.5 million, and Rs 200 thousand respectively. Such limits in respect of "TINY"
ENTERPRISES would now be increased from the present Rs 200 thousand toRs. 500
thousand, irrespective of location of the unit. Limit in plant and machinery for determining
the status of SSI/Ancillary units as on date is Rs 10 million.

Small scale industries: The small scale industries sector has progressively acquired prominent place
inthe development activities of the country. Consequent upon the revision of the definition of the
small-scale industry, the size and scope of the small scale industries sector has been
considerably widened, thus enabling a large number of industrial units to avail themselves
of increased assistance and facilities. The socio-economic significance of the role of small-scale
industries in relation to t h e e c o n o m i c d e v e l o p m e n t o f t h e c o u n t r y h a s b e e n m o r e
fu l l y real i zed i n t h e post -i n depen den ce peri od. I t i s refl ect ed i n t he t w o
I n d u s t r i a l P o l i c y R e s o l u t i o n s o f t h e Government of India adopted in 1948 and 1956 as well
as in the progressive allocations made for the development of this vital sector in the Five-Year Plans
e.g. Agricultural Implement, Dyeing, Washing and Finish ing, Calico Printing, Nutsa n d
Bolts, Electrical Goods, Cotton Ginning and Oilseed Crushing, Surgical
Instruments, Plastic Goods, Paints and Varnishes, Umbrella Ribs, Radio
Assembling

Statutory corporations: Statutory Corporation are public enterprises into existence by a Special Act
of the parliament. The Act defines its powers and functions, rules and regulations governing its
employees and its relationship with government departments
In your opinion which criteria serves the better?

Industry classification or industry taxonomy organizes companies into industrial groupings based on
similar production processes, similar products, or similar behavior in financial markets.

A wide variety of taxonomies is in use, sponsored by different organizations and based on different
criteria.

The NAICS Index File lists 19745 rubrics beyond the 6 digits which are not assigned codes.

Besides the widely-used taxonomies above, there are also more specialized proprietary systems:

 Revere Data, line-of-business, about 11,000 leaf nodes

 Industry Building Blocks, line-of-business about 12,000 leaf nodes
 First Research taxonomy, used by Hoover's

Q.2 Show that according to indifference curve approach utility is ordinal magnitude and
consumer is in equilibrium when MRS is equal to price ratio of two goods. Also derive
consumer’s demand curve from this approach. (20)

Marginal propensity to consume (MPC)

In economics, the marginal propensity to consume (MPC) is an empirical metric that quantifies induced
consumption, the concept that the increase in personal consumer spending (consumption) occurs with
an increase in disposable income (income after taxes and transfers). The proportion of the disposable
income which individuals desire to spend on consumption is known as propensity to consume. MPC is
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the proportion of additional income that an individual desires to consume. For example, if a household
earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of
that dollar, the household will spend 65 cents and save 35 cents.

Mathematically, the function is expressed as the derivative of the consumption function with
respect to disposable income .

or

, where is the change in consumption, and is the change in disposable

income that produced the consumption.

Marginal propensity to consume can be found by dividing change in consumption by a change in

income, or . The MPC can be explained with the simple example:

INCOME CONSUMPTION
120 120
180 170

Here ; Therefore, or 83%. For

example, suppose you receive a bonus with your paycheck, and it's $500 on top of your normal annual
earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of
this marginal increase in income on a new business suit, your marginal propensity to consume will be
0.8 ( ).

The above figure illustrates the consumption function. The slope of the consumption function tells us
how much consumption increases when disposable income increases by one rupee. That is, the slope of
the consumption function is the MPC.

The marginal propensity to consume is measured as the ratio of the change in consumption to the
change in income, thus giving us a figure between 0 and 1. The MPC can be more than one if the
subject borrowed money to finance expenditures higher than their income. One minus the MPC equals
the marginal propensity to save (in a two sector closed economy), both of which are crucial to
Keynesian economics and are key variables in determining the value of the multiplier. The MPC is the
rate of change in the Average propensity to consume (APC). When income increases, the MPC falls but
more than the APC. Contrariwise, when income falls, the MPC rises and the APC also rises but at a
slower rate than the former. Such changes are only possible during cyclical fluctuations whereas in the
short-run there is no change in the MPC and .

The MPC relies heavily upon the real (inflation-adjusted) rate of interest. A high rate of interest causes
spending in the future to become increasingly attractive due to the inter-temporal substitution effect on
consumption. Because a rate increase primarily decreases the present value of lifetime wealth, the consumer
relies on becoming a lender to offset this effect. In a two period model, as increases with the
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interest rate, so does future income [ ]. Therefore, every dollar of current
income spent by the consumer is dollars the consumer will not be able to spend in the second
period.

Average Propensity to save (APS)

The average propensity to save (APS) indicates what the household sector does with income. The APS
indicates the portion of income that is used for saving. If, for example, the APS is 0.1, then 10 percent
of income goes for saving.
A saving schedule, such as the one presented to the right, provides data that can be used to run
through a few APS calculations. The first column in this schedule presents household income, ranging
from $0 to $10 trillion. The second column presents saving, ranging from -$1 to $1.5 trillion. The task
at hand is to derive the average propensity to save at each income level.

The average propensity to save is calculated by dividing saving in the second column by income in the
first column. Beginning near the top of the schedule, if household income is $1 trillion, then saving is -
$0.75 trillion, giving an average saving of -0.75.

The MPS plays a central role in Keynesian economics as it quantifies the saving-income relation, which
is the flip side of the consumption-income relation, and thus it reflects the fundamental psychological
law. Marginal Propensity to save is also a key variable in determining the value of the multiplier.

Q.3 (a) Explain why does the assumption of transitivity of preferences means that
indifference curves do not cross each other. (10+10)

For any two alternative consumption points x and x' that are both within the consumer's budget set, a
choice of x rather than x' indicates a preference for x relative to x', which is written x x'. Since x and
x' may be equally good from the perspective of this consumer, x x' means that "the consumer likes x
at least as much as she likes x'."

If we make several assumptions about properties of preferences, then we will be able later to
represent preferences in a convenient way, called a utility function. Most of these properties are fairly
natural, especially when the number of alternatives is small.

Properties of Preferences

There are several properties of preferences that together imply that a consumer's choices will be
consistent.

P.1 Preferences are complete

P.1 Preferences are complete

Preferences are complete if for any two consumption points x and x', either x x' (x is at least as good
as x') or x' x (x' is at least as good as x), or both.

For example, x may be one apple and one mango, and x' might be one orange and one carrot. The
property says that when presented with these two alternatives, I can decide that "x is at least as good
as x'" or "x' is at least as good as x." While this appears like a very mild assumption, completeness
asserts that I can do this for every possible pair of choices in the set of alternatives, which may be a
demanding task.

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P.2 Preferences are reflexive

Preferences are reflexive if for all x, x x (x is at least as good as itself).

This assumption is probably the weakest of the five assumptions. In the example above, it would
assert that "I like one apple and one mango at least as well as one apple and one mango."

P.3 Preferences are transitive

Preferences are transitive if x x' and x' x'' implies that x x''.

Transitivity is also intuitive and plausible. If x and x are the same two alternatives as in the example of
P.1, and x'' is one banana and one carrot, then transitivity would assert that if "I like one apple and
one mango at least as well as one orange and one carrot" and ``I like one orange and one carrot at
least as well as one banana and one carrot" then "I like one apple and one mango at least as well as
one banana and one carrot."

P.4 Preferences are strongly monotonic

Preferences are strongly monotonic if for any two commodity points x = (x1, x2) and x' = (x'1, x'2) if
x1 x'1, x2 x'2, and x x', then x' is preferred to x.

Strong monotonicity means that for a specified consumption level x, there is some point x' close to x
that is preferred to x. The point x' might have more of both commodities, or it may only have more of
one commodity.

(b) Derive the demand curve of a consumer under the revealed preference theory.

Price elasticity of demand measures the responsiveness of demand after a change in price

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided by the percentage change in price

Since changes in price and quantity usually move in opposite directions, usually we do not bother to
put in the minus sign. We are more concerned with the co-efficient of elasticity of demand.

Example: Demand for rail services

At peak times, the demand for rail transport becomes inelastic – and higher prices are charged by rail
companies who can then achieve higher revenues and profits

Values for price elasticity of demand

1. If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price
changes – the demand curve will be vertical.
2. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the
percentage change in price), then demand is inelastic.
3. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then
demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving
total spending the same at each price level.
4. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand
is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand.
The price elasticity of demand for this price change is –3

Factors affecting price elasticity of demand

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  The number of close substitutes – the more close substitutes there are in the market, the
more elastic is demand because consumers find it easy to switch
 The cost of switching between products – there may be costs involved in switching. In this
case, demand tends to be inelastic. For example, mobile phone service providers may insist on
a12 month contract.
 The degree of necessity or whether the good is a luxury – necessities tend to have an
inelastic demand whereas luxuries tend to have a more elastic demand.
 The proportion of a consumer’s income allocated to spending on the good – products
that take up a high % of income will have a more elastic demand
 The time period allowed following a price change – demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to search for
cheaper substitutes and switch their spending.
 Whether the good is subject to habitual consumption – consumers become less sensitive
to the price of the good of they buy something out of habit (it has become the default choice).
 Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-
peak times – this is particularly the case for transport services.
 The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are
likely to be more elastic following a price change.

Demand curves with different price elasticity of demand

Elasticity of demand and total revenue for a producer / supplier

The relationship between elasticity of demand and a firm’s total revenue is an important one.

 When demand is inelastic – a rise in price leads to a rise in total revenue – a 20% rise
in price might cause demand to contract by only 5% (Ped = -0.25)
 When demand is elastic – a fall in price leads to a rise in total revenue - for example a
10% fall in price might cause demand to expand by only 25% (Ped = +2.5)

Peak and Off-Peak Demand and Prices

Why are prices for package holidays more expensive during school holiday weeks? Why are rail fares
more expensive at peak times? During peak demand periods, market demand is higher and also more
price inelastic. This allows producers to sell their products for higher prices and make increased profits.

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The table below gives an example of the relationships between prices; quantity demanded and total
revenue. As price falls, the total revenue initially increases, in our example the maximum revenue
occurs at a price of £12 per unit when 520 units are sold giving total revenue of £6240.

Price Quantity Total Revenue Marginal Revenue

£ per unit Units £s £s
20 200 4000
18 280 5040 13
16 360 5760 9
14 440 6160 5
12 520 6240 1
10 600 6000 -3
8 680 5440 -7
6 760 4560 -11

Consider the elasticity of demand of a price change from £20 per unit to £18 per unit. The % change
in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i.e. highly
elastic).

In this situation when demand is price elastic, a fall in price leads to higher total consumer spending /
producer revenue

Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit.
The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of elasticity of –
0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a reduction in total revenue.

Change in the market What happens to total revenue?

Ped is inelastic and a firm raises its price. Total revenue increases
Ped is elastic and a firm lowers its price. Total revenue increases
Ped is elastic and a firm raises price. Total revenue decreases
Ped is -1.5 and the firm raises price by 4% Total revenue decreases
Ped is -0.4 and the firm raises price by 30% Total revenue increases

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Ped is -0.2 and the firm lowers price by 20% Total revenue decreases
Ped is -4.0 and the firm lowers price by 15% Total revenue increases

Elasticity of demand and indirect taxation

Many products are subject to indirect taxes. Good examples include the duty on cigarettes (cigarette
taxes in the UK are among the highest in Europe) alcohol and fuel. Here we consider the effects of
indirect taxes on costs and the importance of elasticity of demand in determining the effects of a tax
on price and quantity.

A tax increases the costs of a business causing an inward shift in supply. The vertical distance between
the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier
may be able to pass on some or all of this tax to the consumer by raising price. This is known as
shifting the burden of the tax and this depends on the elasticity of demand and supply.

Consider the two charts above.

 In the left hand diagram, the demand curve is drawn as price elastic. The producer must
absorb the majority of the tax itself (i.e. accept a lower profit margin on each unit sold).
When demand is elastic, the effect of a tax is still to raise the price – but we see a bigger fall
in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand.
 In the right hand diagram, demand is drawn as price inelastic (i.e. Ped <1 over most of the
range of this demand curve) and therefore the producer is able to pass on most of the tax to
the consumer through a higher price without losing too much in the way of sales. The price
rises from P1 to P2 – but a large rise in price leads only to a small contraction in demand
from Q1 to Q2.

Example: Will price cuts work for Sony?

Sony is cutting the price of its PlayStation 3 gaming console by nearly a fifth, hoping to jump-start
sales of a five-year old device losing ground to Microsoft's Xbox. The price tag on the 160 GB version
has fallen to £200 in the UK and from €299 to €249 in Europe

The usefulness of price elasticity for producers

Firms can use PED estimates to predict:

 The effect of a change in price on the total revenue & expenditure on a product.
 The price volatility in a market following changes in supply – this is important for commodity
producers who suffer big price and revenue shifts from one time period to another.

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  The effect of a change in an indirect tax on price and quantity demanded and also whether
the business is able to pass on some or all of the tax onto the consumer.
 Information on the PED can be used by a business as part of a policy of price discrimination.
This is where a supplier decides to charge different prices for the same product to different
segments of the market e.g. peak and off peak rail travel or prices charged by many of our
domestic and international airlines.
 Usually a business will charge a higher price to consumers whose demand for the product is
price inelastic

Price elasticity of demand and changing market prices

The price elasticity of demand will influence the effects of shifts in supply on price and quantity in a
market. This is illustrated in the next two diagrams.

In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward shift
of supply – which leads to a large rise in equilibrium price and quantity and only a relatively small
change in the market price. In the right hand diagram, a similar increase in supply is drawn together
with an inelastic demand curve. Here the effect is more on the price. There is a sharp fall in the price
and only a relatively small expansion in the equilibrium quantity.

Q.4 (a) Describe the determinants of elasticity of demand.

In the earlier discussion we were able to understand the relationship between demand and price.
Recapitulating the discussion briefly, The Law of Demand states that “Other things remaining the same
the demand for a commodity increases when its price falls and it decreases when its price
increases".Thus according to the law of demand there is an inverse relationship between price and
quantity demanded, other things remaining the same. These other things which are assumed to be
constant are taste or preference of the consumer, income of the consumer, prices of related goods etc
.If these factors undergo a change, then the inverse relationship may not hold good. However we also
observe that for commodities like salt or rice we do not notice much of a change in demand whereas in
case of goods like Air conditioners, Cars etc even with a small change there is substantial increase in
demand. The Law of demand while stating the relationship between demand and price mentions only
the direction of change in demand but does not mention anything about the magnitude of the change
which is very essential in decision making process for the producer and Government.

Definition

Price Elasticity of demand is the degree of responsiveness of demand to a change in its price.In
technical terms it is the ratio of the percentage change in demand to the percentage change in price.
Thus,
Ep = Pecentage change in quantity demanded/Percentage change in price

In mathematical terms it can be represented as: Ep =(∆q/∆p) (p/q)

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From the definition it follows that

1. when percentage change in quantity demanded is greater than the percentage change in price
then, price elasticity will be greater than one and in this case demand is said to be elastic.
2. when percentage change in quantity demanded is less than the percentage change in price
then, price elasticity will be less than one and in this case demand is said to be inelastic.
3. when percentage change in quantity demanded is equal to the percentage change in price then
price elasticity will be equal to one and in this case demand is said to be unit elastic.

Percentage change in price = (New price –Old Price)/ Old price

= ( 8- 7)/ 7
= o.14
Price elasticity of demand = (percentage change in demand)/(Percentage change in price)
= - 0.04 /0.14
= -0.28
Since the Elasticity of Demand is less than one Demand is inelastic . In other words we can say that for
a 14% increase in price ,demand has declined only by 4% . The negative sign indicates the inverse
relationship between demand and price.

Diagrammatic representation Of Price Elasticity Of Demand

13
Determinants of Price Elasticity Of Demand

There are number of factors which determine the price elasticity of demand. Let us consider some of
these factors.

Firstly if close substitutes are available then there is a tendency to shift from one product to another
when the price increases and demand is said to be elastic. For example, demand for two brands of tea.
If the price of one brand A increases then the demand for the other brand B increases. In other words
greater the possibility of substitution greater the elasticity.

Secondly how much of the income is spent on a commodity by the consumer. Greater the proportion
of income spent on the commodity greater will be the elasticity.

Thirdly the number of uses to which the commodity can be put is important factor determining
elasticity. If the commodity can be put to many uses then the elasticity will be greater.

Fourthly if two commodities are consumed jointly then increase in the price of one will reduce the
demand for both.

Fifthly time element has an important role to play in determining the elasticity of demand . Demand
is more elastic if time involved is long. In the short run , it is difficult to substitute one commodity for
another.

Sixthly Cost of switching between different products and services.There may be significant
transaction costs involved in switching.In this case demand tends to be relatively inelastic.For example
,mobile phone service providers may include penalty clauses in their contracts.

Seventhly Who makes the payment, Where the purchaserdoes not directlypay for the goodthey
consume, such as perks enjoyed by employees,demand is likely to be more inelastic.

Finally Brand Loyalty,An attachment to a certain brand either out of tradition or because of propriety
barriers can override sensitivity to price changes, resulting in more inelastic demand.

Measurement of Elasticity of Demand

i. Percentage Method .
i. Point Elasticity Method.
ii. Total Outlay Method.
iii. Arc Elasticity.

Let us discuss each of these measures in detail.

Percentage Method

Price elasticity can be measured by dividing the percentage change in quantity demanded in response
to a small change in price ,by the percentage change in price. The definition and the numerical
example disussed earlier explains the percentage method. Mathematically , price elasticity of demand
ha s a negative sign since the change in quantity demanded is in opposite direction to the change in its
price.Only goods which do not confirm to the Law of Demand like Veblen good or Giffen good have
positive price elasticity of demand.Hence for sake of convenience in understanding the magnitude of
response of quantity demanded of a good to a change in its price we ignore the negative sign and take
into account only the numerical value of the elasticity.The accuracy of the percentage method is
questioned on the ground that the value of the elasticity depends on which value is taken as the
starting point in the calculation of percentage. For example, if quantity demanded increases from 10
units to 15 units, the percentage change is 50%, i.e., (15 − 10) ÷ 10 (converted to a percentage). But
if quantity demanded decreases from 15 units to 10 units, the percentage change is −33.3%, i.e., (15
− 10) ÷ 15.Two alternative measures avoid or minimise the shortcoming of the percentage method.
Now we proceed to understand the Point elasticity method.

14
Total Outlay Method

From the changes in the total expenditure made as a result of changes in its price ,we can know the
price elasticity of demand for the good. However it should be taken note that it is possible to identify
whether price elasticity of demand will be greater than one, less than one or equal to one only. The
exact or accurate price elasticity of demand cannot be found. Let us under the relationship precisely.

Unit Elasticity:

With a change in the price of the good, quantity demanded increases, the total expenditure remaining
the same, elasticity of demand is equal to one. The reason for this is ,if total outlay has to be the same
then the percentage change in price has to be equal to percentage change in quantity demanded.
Elasticity greater than one: With a decline in the price of the good, quantity demanded increases, the
total expenditure also increases, elasticity of demand is greater than one. The reason for this is ,if total
outlay has to increase then the percentage change in quantity demand has to be greater than
percentage change in price. Similarly due to an increase in the price of a good if there is a fall in the
demand and as a result there is a decline in the total expenditure then also the elasticity of demand is
greater than one. Elasticity Less than one : With a decline in the price of the good, quantity demanded
decrease, the total expenditure also decreases, elasticity of demand is less than one. The reason for
this is ,if total outlay has to decreases then the percentage change in quantity demand has to be less
than percentage change in price. Similarly due to an increase in the price of a good if there is an
increase in the demand and as a result there is a increase in the total expenditure then also the
elasticity of demand is less than one.

(b) Measure the elasticity of demand at one point and between two points on a curved
demand curve. (10+10)

The concept of point elasticity is used when we want to know relative price elasticity of demand at a
given point on the demand curve to make some decisions about price variation. We try to know impact
on revenue which is total of multiplying price with quantity demand (PxQ).

Dominick Salvatore defines point elasticity of demand as:

“The price elasticity of demand at a particular point on the demand curve.”

(Source: Managerial Economics in a Global Economy, 7th Edition)

To simplify the concept, we take mid-point of the demand curve as a point (C) where elasticity is unity
(Ed=1). Elasticity of demand decreases (Ed<1) when we move to the right direction from point C and
increases (Ed>1) the other way around.

The elasticity is measured by placing points on a given graph that’s why it is also called graphic
method.

15
There are a number of ways to calculate it. The sophisticated methods seem too complicated but
simple ones are more popular. We can calculate price elasticity of demand on different points of linear
or non-linear demand curves.

Point Elasticity on a Linear Demand Curve

In above graph we suppose to sell 80 items for $80.00. We also suppose unitary elasticity of demand
at point C by taking it as a mid-point on the curve. We can calculate point elasticity on different points
of the demand curve by using this formula:

The elasticity at point C can be calculated as:

Ed = CD/CA = 40/40 = 1

Elasticity at point D can be calculated as under:

Ed = ED/AD = 20/60 = 0.33 (<1)

Elasticity at point B can be calculated as under:

Ed = BE/BA = 60/20 = 3 (>1)

By applying this method we find out that elasticity of demand at different points along a linear
demand curve is different. At high prices, the demand is elastic while at lower the demand is relatively
inelastic. At mid-point the elasticity is unit elastic.

Point Elasticity On a Non-Linear Demand Curve

In this graph the elasticity on DD’ demand curve at point C can be measured by drawing a tangent (a
line which touch the curve but does not intersect). At point C the elasticity would be:

Ed = BM/MO = BC/CA = 40/20 = 2 (>1).

On this point the elasticity is greater than unity. It lies above the demand curve DD’.

At point C, the elasticity is greater than unity and it situated

16
Important Tips

We have been using round numbers in our calculations to simplify things for the visitors. However, in a
real life situation, a change in price may result in a very small decrease or increase in the quantity
demanded or the revenue generated. It is possible that you decrease price of your product by 10% and
be able to increase your revenue just by 2%.

In such situations it becomes very critical choice to go for a change in price. It depends upon costs of
your product to decide what is better for your revenue generation.

Secondly, there are certain situations when elasticity goes infinite or falls to zero. In our calculations,
there may be points beyond point A where elasticity is infinite and beyond E, the elasticity may be
zero.

Q.5 Explain consumer’s equilibrium diagrammatically as well as mathematically by using

necessary and sufficient conditions. (20)

All consumers strive to maximize their utility. We try to get as much satisfaction as we can. The
consumer’s scale of preference is derived by means of indifference mapping that is a set of indifference
curves which ranks the preferences of the consumer. Getting is to the indifference curve which is
farthest from the origin gives the highest total utility. Although the goal of the consumer is
maximization of satisfaction, the means of achieving the goal is not clear. Higher indifference curve not
only gives higher satisfaction but also are more expensive.

Conditions for consumer's equilibrium:

 1.A given budget line must be tangent to an indifference curve , or the marginal rate of
substitution between commodity X and commodity Y (MRSx,y) must be equal to the price ratio

between the two goods .

 2. At the point of equilibrium, indifference curve must be convex to the origin.

The limitation on utility maximization is evident. We want to reach the highest indifference curve with
our limited income. You can go only as far as your budget constraint allows. Suppose you have only 50
rupees to spend on good X and good Y. The price of a unit of X is 10 rupees where as the price of good
Y is 5 rupees. You can have as many as 5 units of good X if you want to forsake good Y. Similarly you
can have 10 units of good Y with the same 50 rupees. The budget constraints illustrates all
combination of goods you can buy with a limited income. In this case the budget line illustrates the
combination of X and Y , that can be purchased with 50 rupees.

17
Above diagram explain the process of consumer’s equilibrium. The consumer’s preference scale is
described by means of indifference mapping .Then we impose a budget line that reflects our income. In
this case we have r 50 and the price of good X and good Y is r 10 and r 5 respectively. Therefore, we
can afford only those combinations that are on or inside the price line GH.

In this diagram every combination on the price line GH cost you the same amount of money. In order
to maximize the utility, we will try to reach the highest indifference curve which you could get with a
given expenditure of money and given prices of two goods. The budget line touches IC2 at point E
represents the most utility. This is the highest attainable indifference curve with which you can get
OQ1 units of good X and OQ2 units of good Y for r 50. Any other affordable combinations on the price
line GH gives you less satisfaction, because that will be on a lower indifference curve IC1. With this we
conclude that the point of tangency between the budget line and an indifference curve represents
optimal consumption. It is the affordable combination that maximizes our utility.

At the tangency point E the slope of the price line GH and indifference curve are equal. Slope of the
indifference curve shows the marginal rate of substitution of X for Y. The price line indicates the ratio
between the prices of two goods (PX/PY). Thus at the equilibrium point E,MRSXY=Price of good x/Price
of good y= PX/PY

The tangency between the given price line and an indifference curve is a necessary but not a sufficient
condition consumer’s equilibrium .The second condition for consumer’s equilibrium is convexity of
indifference curve to the origin .Which means MRSxy is falling at the point of equilibrium.

In fig no -1 indifference curve IC2 is convex to the origin at point E, is the optimum or best choice for
the consumer .The consumer attains a stable equilibrium position where he is able to consume the
most preferred combination which gives him highest utility. In figure no -2 ,IC1 is concave to the origin
at point E. Price line AB is tangent to the indifference curve IC1 at point E and the marginal rate of
substitution of X for Y is equal to the price ratio of two goods (PX/PY). But E cannot be the position of
stable equilibrium because satisfaction would not be maximum .There are other combinations like G
and H in the given price line will be on higher indifference curve .The consumer by moving along the
given price line AB can go to other tangency point such as G and H and obtain greater satisfaction than
at point E.

Marginal Utility and Price

The slope of the indifference curve shows the marginal rate of substitution of good X for good Y, while
the slope of price line indicates the ratio between prices of two goods i.e. ( PX /PY). Consumer
equilibrium was represented as the combination of good X and good Y can be written as

18
 =

Alternatively,

This equation explains that at the point of equilibrium the relative marginal utilities of good X and good
Y should equal to their relative prices. In other words , if good X cost twice as much as good Y , then
marginal utility of good X must yield double , then the consumer is in an optimal state.

The slope of the budget constraint equal the relative prices of the two goods. In Fig-1, the slope of the
price line equal to the price of goods X and good Y. It means the rate of substitution between the good
X and good Y is 1:2. The relative marginal utilities of the two goods are reflected in the slope of the
indifference curve. It is the marginal r ate of substitution which is equal to the relative marginal utilities
of the two goods.

At the point of optimal consumption E in fig-1 the budget constraint is tangent to the indifference curve
IC2. Which means?

Or Marginal rate of substitution of X for Y =

Consumer's Equilibrium and Non-normal cases

Indifference curves are usually convex to the origin .Convexity of indifference curve implies the
marginal rate of substitution of X for Y decreases .The possibility of concavity cannot be ruled out in
some exceptional cases. But at the same time concavity implies increasing marginal rate of
substitution of X for Y .The consumer will choose or buy only one good.

Fig No-3

The price line AB is tangent to the indifference curve IC2 . But the consumer cannot be in equilibrium
at point E because it can obtain grater satisfaction by moving along the given price line .Consumers

19
satisfaction increases by either moving upward or downward till he reaches the extremity points A on
the y-axis or B on the x –axis.

In these cases consumer will choose only one of two goods, depending on his scale of preference and
level of satisfaction between good x and good y. In the above diagram a lies on a higher indifference
curve than Therefore the consumer will choose only Y and buy OA of commodity Y. It is also noted that
consumer is not tangent to the indifference curve at point A .Therefore consumer’s equilibrium cannot
be establish at point A .

In case of perfect complementary goods ,the shape of the indifference curve have a right –angled .The
equilibrium of the consumer cannot be established because only one point of the indifference curve is
tangent to the price line AB.

Q.6 Explain the relationship among price effect. Substitution effect and income effect for
normal and inferior goods. (20)

Demand changes due to two factors. Firstly demand changes due to price and secondly demand
changes on account of changes in other factors other than price. When demand changes as a change in
corresponding price this is said to be change in quantity demanded. On the other hand the change in
demand due to other factors is known as "change in demand."

The whole demand schedule and demand curve change due to charge in the factors other than the
price. There is complete shift of demand curve as a result of change in the factors other than price.
Thus in the case of change in demand, there is complete change in demand function. A fall in demand
leads to a downward shift of demand curve and a rise in demand cause the demand curve to shift
upwards.

(1) Tastes and preferences of the consumer:

Tastes include fashion, habit, customs etc. A good for which consumers tastes and preferences are
greater claim higher demand. Thus the demand curve lies at a higher level. With the change in
consumer's taste and preference for particular commodity the demand for that commodity declines.

If the taste goes up its amount demanded becomes high even at a high price. Those goods which go
out of fashion of people no longer remains attractive to them. So the demand for them decreases.

(2) Income of the people:

The demand for goods depends upon the income of the people. There is direct relation between income
and demand for immodesties. A rise in income gives rise to greater purchasing power. Thus increase in
income has a positive effect for a good.

20
With a rise and fall in income the demand curve shifts upward and downward respectively. But in case
of giffen goods the income effect is negative.

(3) Changes in prices of the related goods:

The demand for a commodity is affected by the changes in the prices of other related commodities.
The related commodities may be (i) substitute and (ii) complementary. A commodity is said to be
substitute only when it yields the same utility and satisfaction in place of other. Complementary goods
are jointly demanded. They are consumed untidily for satisfaction.

Tea and coffee are substitute’s goods but pen and ink are complementary commodities. When the price
of a substitute of a good falls the demand for that good declines and when the price of the substitute
rises, the demand for that good increases.

In case of complementary goods there is opposite relationship between price of one commodity and
the amount demanded for the other. The effect in change in price of related goods on the amount
demanded is called as Gross Demand.

(4) Future expectation:

Present demand for a commodity also depends on the future expectation of the change in price. If
people expect that the price of a commodity will rise in future, they will buy more even at a high price
so as to escape the further rise in price in future.

Similarly any expectation of the fall in price in future will diminute demand for a commodity as people
expect further fall in price. Similarly if buyers expect their incomes to rise in future, they may increase
the present demand.

(5) Population:

Rise of population also gives rise to demand for necessaries of life. The composition and size of
population affect the demand. With high birth rate demand for milk food, medicines and garments
increase. The rise in the proportion of adult, old and woman also shape the nature of demand
accordingly.

(6) Income distribution:

Income distribution in the society affects the demand for goods. If the distribution of income is even
then the demand for goods is greater. On the other hand if the distribution of income is unequal, the
demand for consumer goods will be comparatively less. Cross price elasticity (CPed) measures the
responsiveness of demand for good X following a change in the price of a related good Y. We are
looking here at the effect that changes in relative prices within a market have on the pattern of
demand. With cross elasticity we make a distinction between substitute and complementary products.

21
Cross price elasticity of demand – analysis diagrams

Substitutes:

With substitute goods such as brands of cereal, an increase in the price of one good will lead to an
increase in demand for the rival product. The cross price elasticity for two substitutes will be positive.

For example, the iPhone now provides genuine competition for the Blackberry in providing users with
‘push technology’ to send all emails through to a mobile device.

Another good example is the cross price elasticity of demand for music. Sales of digital music
downloads have been soaring with the growth of broadband and falling prices for downloads. As a
result, sales of traditional music CDs are declining at a steep rate.

Complements:

Complements are in joint demand

The CPED for two complements is negative.

The stronger the relationship between two products, the higher is the co-efficient of cross-price
elasticity of demand. When there is a strong complementary relationship between two products, the
cross-price elasticity will be highly negative. An example might be games consoles and software games

Unrelated products

Unrelated products have a zero cross elasticity for example the effect of changes in taxi fares on the
market demand for cheese!

Pricing for substitutes:

If a competitor cuts the price of a rival product, firms use estimates of CPED to predict the effect on
demand and total revenue of their own product.

Pricing for complementary goods:

Popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong
complements. Popcorn has a high mark up i.e. pop corn costs pennies to make but sells for more than

22
a pound. If firms have a reliable estimate for CPed they can estimate the effect, say, of a two-for-one
cinema ticket offer on the demand for popcorn.

The additional profit from extra popcorn sales may more than compensate for the lower cost of entry
into the cinema. For some movie theatres, the revenue from concessions stalls selling popcorn; drinks
and other refreshments can generate as much as 40 per cent of their annual turnover.

Brand and cross price elasticity

When consumers become habitual purchasers of a product, the cross price elasticity of demand against
rival products will decrease. This reduces the size of the substitution effect following a price change
and makes demand less sensitive to price. The result is that firms may be able to charge a higher
price, increase their total revenue and achieve higher profits.

Q.7 Measure the responsiveness of demand symbolically as well as graphically, if change

in its price is very small. (20)

Price elasticity of demand measures the responsiveness of demand after a change in price

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided by the percentage change in price

Since changes in price and quantity usually move in opposite directions, usually we do not bother to
put in the minus sign. We are more concerned with the co-efficient of elasticity of demand.

Example: Demand for rail services

At peak times, the demand for rail transport becomes inelastic – and higher prices are charged by rail
companies who can then achieve higher revenues and profits

Values for price elasticity of demand

5. If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price
changes – the demand curve will be vertical.
6. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the
percentage change in price), then demand is inelastic.
7. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then
demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving
total spending the same at each price level.
8. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand
is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand.
The price elasticity of demand for this price change is –3

Factors affecting price elasticity of demand

 The number of close substitutes – the more close substitutes there are in the market, the
more elastic is demand because consumers find it easy to switch
 The cost of switching between products – there may be costs involved in switching. In this
case, demand tends to be inelastic. For example, mobile phone service providers may insist on
a12 month contract.
 The degree of necessity or whether the good is a luxury – necessities tend to have an
inelastic demand whereas luxuries tend to have a more elastic demand.
 The proportion of a consumer’s income allocated to spending on the good – products
that take up a high % of income will have a more elastic demand
 The time period allowed following a price change – demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to search for
cheaper substitutes and switch their spending.

23
  Whether the good is subject to habitual consumption – consumers become less sensitive
to the price of the good of they buy something out of habit (it has become the default choice).
 Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-
peak times – this is particularly the case for transport services.
 The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are
likely to be more elastic following a price change.

Demand curves with different price elasticity of demand

Elasticity of demand and total revenue for a producer / supplier

The relationship between elasticity of demand and a firm’s total revenue is an important one.

 When demand is inelastic – a rise in price leads to a rise in total revenue – a 20% rise
in price might cause demand to contract by only 5% (Ped = -0.25)
 When demand is elastic – a fall in price leads to a rise in total revenue - for example a
10% fall in price might cause demand to expand by only 25% (Ped = +2.5)

Peak and Off-Peak Demand and Prices

Why are prices for package holidays more expensive during school holiday weeks? Why are rail fares
more expensive at peak times? During peak demand periods, market demand is higher and also more
price inelastic. This allows producers to sell their products for higher prices and make increased profits.

24
The table below gives an example of the relationships between prices; quantity demanded and total
revenue. As price falls, the total revenue initially increases, in our example the maximum revenue
occurs at a price of £12 per unit when 520 units are sold giving total revenue of £6240.

Price Quantity Total Revenue Marginal Revenue

£ per unit Units £s £s
20 200 4000
18 280 5040 13
16 360 5760 9
14 440 6160 5
12 520 6240 1
10 600 6000 -3
8 680 5440 -7
6 760 4560 -11

Consider the elasticity of demand of a price change from £20 per unit to £18 per unit. The % change
in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i.e. highly
elastic).

In this situation when demand is price elastic, a fall in price leads to higher total consumer spending /
producer revenue

Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit.
The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of elasticity of –
0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a reduction in total revenue.

Change in the market What happens to total revenue?

Ped is inelastic and a firm raises its price. Total revenue increases
Ped is elastic and a firm lowers its price. Total revenue increases
Ped is elastic and a firm raises price. Total revenue decreases
Ped is -1.5 and the firm raises price by 4% Total revenue decreases
Ped is -0.4 and the firm raises price by 30% Total revenue increases

25
Ped is -0.2 and the firm lowers price by 20% Total revenue decreases
Ped is -4.0 and the firm lowers price by 15% Total revenue increases

Elasticity of demand and indirect taxation

Many products are subject to indirect taxes. Good examples include the duty on cigarettes (cigarette
taxes in the UK are among the highest in Europe) alcohol and fuel. Here we consider the effects of
indirect taxes on costs and the importance of elasticity of demand in determining the effects of a tax
on price and quantity.

A tax increases the costs of a business causing an inward shift in supply. The vertical distance between
the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier
may be able to pass on some or all of this tax to the consumer by raising price. This is known as
shifting the burden of the tax and this depends on the elasticity of demand and supply.

Consider the two charts above.

 In the left hand diagram, the demand curve is drawn as price elastic. The producer must
absorb the majority of the tax itself (i.e. accept a lower profit margin on each unit sold).
When demand is elastic, the effect of a tax is still to raise the price – but we see a bigger fall
in equilibrium quantity. Output has fallen from Q to Q1 due to a contraction in demand.
 In the right hand diagram, demand is drawn as price inelastic (i.e. Ped <1 over most of the
range of this demand curve) and therefore the producer is able to pass on most of the tax to
the consumer through a higher price without losing too much in the way of sales. The price
rises from P1 to P2 – but a large rise in price leads only to a small contraction in demand
from Q1 to Q2.

Example: Will price cuts work for Sony?

Sony is cutting the price of its PlayStation 3 gaming console by nearly a fifth, hoping to jump-start
sales of a five-year old device losing ground to Microsoft's Xbox. The price tag on the 160 GB version
has fallen to £200 in the UK and from €299 to €249 in Europe

The usefulness of price elasticity for producers

26
Firms can use PED estimates to predict:

 The effect of a change in price on the total revenue & expenditure on a product.
 The price volatility in a market following changes in supply – this is important for commodity
producers who suffer big price and revenue shifts from one time period to another.
 The effect of a change in an indirect tax on price and quantity demanded and also whether
the business is able to pass on some or all of the tax onto the consumer.
 Information on the PED can be used by a business as part of a policy of price discrimination.
This is where a supplier decides to charge different prices for the same product to different
segments of the market e.g. peak and off peak rail travel or prices charged by many of our
domestic and international airlines.
 Usually a business will charge a higher price to consumers whose demand for the product is
price inelastic

Price elasticity of demand and changing market prices

The price elasticity of demand will influence the effects of shifts in supply on price and quantity in a
market. This is illustrated in the next two diagrams.

In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward shift
of supply – which leads to a large rise in equilibrium price and quantity and only a relatively small
change in the market price. In the right hand diagram, a similar increase in supply is drawn together
with an inelastic demand curve. Here the effect is more on the price. There is a sharp fall in the price
and only a relatively small expansion in the equilibrium quantity.

Q.8 Which one, a smooth isoquant or a kinked isoquant is a better approximation to a

real production function and why? (20)

The word 'iso' is of Greek origin and means equal or same and 'quant' means quantity. An isoquant
may be defined as:

"A curve showing all the various combinations of two factors that can produce a given level of output.
The isoquant shows the whole range of alternative ways of producing the same level of output".

The modern economists are using isoquant, or "ISO" product curves for determining the optimum
factor combination to produce certain units of a commodity at the least cost.

27
An isoquant (isoproduct) is a curve on which the various combinations of labour and capital show the
same output. According to Cohen and Cyert, “An isoproduct curve is a curve along which the maximum
achievable rate of production is constant.” It is also known as a production indifference curve or a
constant product curve. Just as indifference curve shows the various combinations of any two
commodities that give the consumer the same amount of satisfaction (iso-utility), similarly an isoquant
indicates the various combinations of two factors of production which give the producer the same level
of output per unit of time. Table 24.1 shows a hypothetical isoquant schedule of a firm producing 100
units of a good. Secondly, on an indifference map one can only say that a higher indifference curve
gives more satisfaction than a lower one, but it cannot be said how much more or less satisfaction is
being derived from one indifference curve as compared to the other, whereas one can easily tell by
how much output is greater on a higher isoquant in comparison with a lower isoquant.

Isoquants are negatively inclined:

If they do not have a negative slope, certain logical absurdities follow. If the isoquant slopes upward to
the right, it implies that both capital and labour increase but they produce the same output. In Figure
24.2 (A), combination В on the IQ curve having a larger amount of both capital and labour (ОС1 +OL1
> ОС + OL) will yield more output than before. Therefore, point A and В on the IQ curve cannot be of
equal product.

Suppose the isoquant is vertical as shown in Figure 24.2 (B), which implies a given amount of labour is
combined with different units of capital. Since OL of labour and OC1 of capital will produce a larger
amount than produced by OL of labour and ОС of capital, the isoquant IQ cannot be a constant product
curve.

Take Figure 24.2 (С) where the isoquant is horizontal which means combining more of labour with the
same quantity of capital. Here ОС of capital and OL1 of labour will produce a larger or smaller amount
than produced by the combination ОС of capital and OL of labour. Therefore, a horizontal isoquant
cannot be an equal product curve.

Thus it is clear that an isoquant must slope downward to the right as shown in Figure 24.2 (D) where
points A and В on the IQ curve are of equal quantity. As the amount of capital decreases from ОС to
OC1 and that of labour increases from OL to OL1 so that output remains constant.

(2) An Isoquant lying above and to the right of another represents a higher output level. In Figure
24.3 combination В on IQ1 curve shows larger output than point A on the curve IQ. The combination of
ОС of capital and OL of labour yields 100 units of product while OC1 of capital and OL1 of labour
produce 200 units. Therefore, the isoquant IQ1 which lies above and to the right of the isoquant IQ,
represents a larger output level.

28
(3) No two isoquants can intersect each other. The absurd conclusion that follows when two isoquants
cut each other is explained with the aid of Figure 24.4. On the isoquant IQ, combination A =B. And on
the isoquant IQ1 combination R=S. But combination S is preferred to combination B, being on the
higher portion of isoquant IQ1. On the other hand, combination A is preferred to R, the former being on
the higher portion of the isoquant IQ. To put it algebraically, it means that S> В and R< A. But this is
logically absurd because S combination is as productive as R and A combination produces as much as
B. Therefore, the same combination cannot both be less and more productive at the same time. Hence
two isoquants cannot intersect each other.

Diagram/Graph:

The alternative techniques for producing a given level of output can be plotted on a graph.

The figure 12.1 shows y the 100 units isoquant plotted to ISO product schedule. The five factor
combinations of X and Y are plotted and are shown by points a, b, c, d and e. if we join these points, it
forms an 'isoquant'.

An isoquant therefore, is the graphic representation of an iso-product schedule. It may here be noted
that all the factor combinations of X and Y on an iso-product curve are technically efficient

29
combinations. The producer is indifferent as to which combination he uses for producing the same level
of output. It is in this way that an iso product curve is also called 'production indifference curve'. In the
figure 12.1, ISO product IP curve represents the various combinations of the two inputs which produce
the same level of output (100 meters of cloth).

Isoquant Map:

An isoquant map shows a set of iso-product curves. Each isoquant represents a different level of
output. A higher isoquant shows a higher level of output and a lower isoquant represents a lower level
of output.

Types of Isoquant

Major four types fo isoquant are:

1. Linear Isoquant: This type assumes perfect substitutability of factors of production: a given
commodity may be produced by using only capital, or only labour, or by an infinite combination
of K and L.
2. Input-Output Isoquant: This assumes strict complementarity[that is, zero substitutability] of
the factors of production. The isoquant take the shape of a right angle. This type of isoquant is
also called 'Leontief isoquant' after Leontief, who invented the input-output ananlysis.
3. Kinked Isoquant: This assmes limited substitutability of K and L. There are only a few
processes for producing any one commodity. Substitutability of factors is possibleonly at the
kinks. This form is also called 'activity analysis-isoquant' or 'linear-programming isoquant',
because it is basically used in linear programming.
4. Smooth , Convex Isoquant: This form assumes continuous substitutability of K and L only
over a certain range, beyond which factors cannot substitute each other. The isoquant appears
as a smooth curve convex to the origin.

Q.9 Derive the cost function form production function. (20)

A production function is a mathematical expression that describes the amount of an output good that
can be produced with a given number of input goods. For example, a production function may be used
to explain the amount of product that can be manufactured using the available raw resources. Fixed
proportion production functions are a type of production function where each unit of output always
requires a fixed amount of input, such as one pound of material or one hour.

Marginal cost function is a derivative of the total cost function. The total cost of producing a good
depends on how much is produced (quantity) and the setup costs. In economics, the variation of cost
with quantity is called variable cost and the setup cost, which is the same regardless of the quantity
produced, is called fixed cost. The marginal cost function measures the extra amount of resources it
takes to produce one more unit of good. Thus, as its name implies, marginal cost is calculated at the
"margin," a place of high interest for economic theorists. The marginal cost function of a firm is also its
supply function.

Process of decision-making

In the process of decision-making, a manager should understand clearly the relationship between the
inputs and output on one hand and output and costs on the other. The short run production estimates
are helpful to production managers in arriving at the optimal mix of inputs to achieve a particular
output target of a firm. This is referred to as the ‘least cost combination of inputs’ in production
analysis. Also, for a given cost, optimum level of output can be found if the production function of a
firm is known. Estimation of the long run production function may help a manager in understanding
and taking decisions of long term nature such as capital expenditure. Estimation of cost curves will
help production manager in understanding the nature and shape of cost curves and taking useful
decisions. Both short run cost function and the long run cost function must be estimated, since both
sets of information will be required for some vital decisions. Knowledge of the short run cost functions
allows the decision makers to judge the optimality of present output levels and to solve decision
problems of production manager. Knowledge of long run cost functions is important when considering
the expansion or contraction of plant size, and for confirming that the present plant size is optimal for
the output level that is being produced.

30
ESTIMATION OF PRODUCTION FUNCTION

The principles of production theory discussed in Unit 7 are fundamental in understanding economics
and provide an important conceptual framework for analysing managerial problems. However, short
run output decisions and long run planning often require more than just this conceptual framework.
That is, quantitative estimates of the parameters of the production functions are required for some
decisions.

Functional Forms of Production Function

The production function can be estimated by regression techniques (refer to MS-8, course on
“Quantitative Analysis for Managerial Applications” to know about regression techniques) using
historical data (either time-series data, or cross-section data, or engineering data). For this, one of the
first tasks is to select a functional form, that is, the specific relationship among the relevant economic
variables. We know that the general form of production function is, Q = f (K,L) Where, Q = output, K =
capital and L = labour. Although, a variety of functional forms have been used to describe
production relationships, only the Cobb-Douglas production function is discussed here. The general
form of Cobb-Douglas function is expressed as: Q = AKa Lb where A, a, and b are the constants that,
when estimated, describe the quantitative relationship between the inputs (K and L) and output
(Q). The marginal products of capital and labour and the rates of the capital and labour inputs are
functions of the constants A, a, and b and. That is,

The sum of the constants (a+b) can be used to determine returns to scale. That is,
(a+b) > 1 Þ increasing returns to scale,
(a+b) = 1 Þ constant returns to scale, and
(a+b) < 1 Þ decreasing returns to scale.

Having numerical estimates for the constants of the production function provides significant
information about the production system under study. The marginal products for each input and
returns to scale can all be determined from the estimated function. The Cobb-Douglas function does
not lend itself directly to estimation by the regression methods because it is a nonlinear relationship.
Technically, an equation must be a linear function of the parameters in order to use the ordinary least-
squares regression method of estimation. However, a linear equation can be derived by taking the
logarithm of each term. That is,

This function can be estimated directly by the least-squares regression technique and the estimated
parameters used to determine all the important production relationships. Then the antilogarithm of
both sides can be taken, which transforms the estimated function back to its conventional
multiplicative form. We will not be studying here the details of computing production function since
there are a number of computer programs available for his purpose. Instead, we will provide in the
following section some empirical estimates of Cobb-Douglas production function and their
interpretation in the process of decision making.

31
Types of Statistical Analyses

Once a functional form of a production function is chosen the next step is to select the type of
statistical analysis to be used in its estimation. Generally, there are three types of statistical analyses
used for estimation of a production function. These are: (a) time series analysis, (b) cross-section
analysis and(c) engineering analysis.

a) Time series analysis:

The amount of various inputs used in various periods in the past and the amount of output produced in
each period is called time series data. For example, we may obtain data concerning the amount of
labour, the amount of capital, and the amount of various raw materials used in the steel industry
during each year from 1970 to 2000. On the basis of such data and information concerning the annual
output of steel during 1970 to 2000, we may estimate the relationship between the amounts of the
inputs and the resulting output, using regression techniques. Analysis of time series data is appropriate
for a single firm that has not undergone significant changes in technology during the time span
analysed. That is, we cannot use time series data for estimating the production function of a firm that
has gone through significant technological changes.

There are even more problems associated with the estimation a production function for an industry
using time series data. For example, even if all firms have operated over the same time span, changes
in capacity, inputs and outputs may have proceeded at a different pace for each firm. Thus, cross
section data may be more appropriate.

b) Cross-section analysis:

The amount of inputs used and output produced in various firms or sectors of the industry at a given
time is called crosssection data. For example, we may obtain data concerning the amount of labour,
the amount of capital, and the amount of various raw materials used in various firms in the steel
industry in the year 2000. On the basis of such data and information concerning the year 2000, output
of each firm, we may use regression techniques to estimate the relationship between the amounts of
the inputs and the resulting output.

c) Engineering analysis:

In this analysis we use technical information supplied by the engineer or the agricultural scientist. This
analysis is undertaken when the above two types do not suffice. The data in this analysis is collected
by experiment or from experience with day-to-dayworking of the technical process. There are
advantages to be gained from and approaching the measurement of the production function from this
angle because the range of applicability of the data is known, and, unlike time series and cross-section
studies, we are not restricted to the narrow range of actual observations.

MANAGERIAL USES OF PRODUCTION FUNCTION

There are several managerial uses of the production function. It can be used to compute the least-cost
combination of inputs for a given output or to choose the input combination that yields the maximum
level of output with a given level of cost. There are several feasible combinations of input factors and it
is highly useful for decision-makers to find out the most appropriate among them. The production
function is useful in deciding on the additional value of employing a variable input in the production
process. So long as the marginal revenue productivity of a variable factor exceeds it price, it may be
worthwhile to increase its use. The additional use of an input factor should be stopped when its
marginal revenue productivity just equals its price. Production functions also aid long-run decision-
making. If returns to scale are increasing, it will be worthwhile to increase production through a
proportionate increase in all factors of production, provided, there is enough demand for the product.
On the other hand, if returns to scale are decreasing, it may not be worthwhile to increase the
production through a proportionate increase in all factors of production, even if there is enough
demand for the product. However, it may in the discretion of the producer to increase or decrease
production in the presence of constant returns to scale, if there is enough demand for the product.

COST FUNCTION AND ITS DETERMINANTS

Cost function expresses the relationship between cost and its determinants such as the size of plant,
32
level of output, input prices, technology, managerial
efficiency, etc. In a mathematical form, it can be expressed as, C = f (S, O, P, T, E…..) Where, C =
cost (it can be unit cost or total cost) S = plant size
O = output level
P = prices of inputs used in production
T = nature of technology
E = managerial efficiency

Determinants of Cost Function

The cost of production depends on many factors and these factors vary from one firm to another firm
in the same industry or from one industry to another
industry. The main determinants of a cost function are:

a) plant size
b) output level
c) prices of inputs used in production,
d) nature of technology
e) managerial efficiency

We will discuss briefly the influence of each of these factors on cost.

a) Plant size:

Plant size is an important variable in determining cost. The scale of operations or plant size and the
unit cost are inversely related in the sense that as the former increases, unit cost decreases, and vice
versa. Such a relationship gives downward slope of cost function depending upon the different sizes of
plants taken into account. Such a cost function gives primarily engineering estimates of cost.

b) Output level:

Output level and total cost are positively related, as the total cost increases with increase in output and
total cost decreases with
decrease in output. This is because increased production requires increased use of raw materials,
labor, etc., and if the increase is substantial, even fixed inputs like plant and equipment, and
managerial staff may have to be increased.

c) Price of inputs:

Changes in input prices also influence cost, depending on the relative usage of the inputs and relative
changes in their prices. This is because more money will have to be paid to those inputs whose prices
have increased and there will be no simultaneous reduction in the costs from any other source.
Therefore, the cost of production varies directly with the prices of production.

d) Technology:

Technology is a significant factor in determining cost. By definition, improvement in technology

increases production leading to increasein productivity and decrease in production cost. Therefore, cost
varies inversely with technological progress. Technology is often quantified as
capital-output ratio. Improved technology is generally found to have higher capital-output ratio.

e) Managerial efficiency:

This is another factor influencing the cost of production. More the managerial efficiency less the cost of
production. It is difficult to measure managerial efficiency quantitatively. However, a and change in
cost at two points of time may explain how organizational or managerial changes within the firm have
brought about cost efficiency, provided it is possible to exclude the effect of other factors.

33
Q.10 “Study of an individual consumer’s behavior falls in the preview of microeconomics”.
Evaluate the statement in the light of microeconomics theory. (20)

All consumers strive to maximize their utility. We try to get as much satisfaction as we can. The
consumer’s scale of preference is derived by means of indifference mapping that is a set of indifference
curves which ranks the preferences of the consumer. Getting is to the indifference curve which is
farthest from the origin gives the highest total utility. Although the goal of the consumer is
maximization of satisfaction, the means of achieving the goal is not clear. Higher indifference curve not
only gives higher satisfaction but also are more expensive.

Conditions for consumer's equilibrium:

 1.A given budget line must be tangent to an indifference curve , or the marginal rate of
substitution between commodity X and commodity Y (MRSx,y) must be equal to the price ratio

between the two goods .

 2. At the point of equilibrium, indifference curve must be convex to the origin.

The limitation on utility maximization is evident. We want to reach the highest indifference curve with
our limited income. You can go only as far as your budget constraint allows. Suppose you have only 50
rupees to spend on good X and good Y. The price of a unit of X is 10 rupees where as the price of good
Y is 5 rupees. You can have as many as 5 units of good X if you want to forsake good Y. Similarly you
can have 10 units of good Y with the same 50 rupees. The budget constraints illustrates all
combination of goods you can buy with a limited income. In this case the budget line illustrates the
combination of X and Y , that can be purchased with 50 rupees.

Above diagram explain the process of consumer’s equilibrium. The consumer’s preference scale is
described by means of indifference mapping .Then we impose a budget line that reflects our income. In
this case we have r 50 and the price of good X and good Y is r 10 and r 5 respectively. Therefore, we
can afford only those combinations that are on or inside the price line GH.

In this diagram every combination on the price line GH cost you the same amount of money. In order
to maximize the utility, we will try to reach the highest indifference curve which you could get with a
given expenditure of money and given prices of two goods. The budget line touches IC2 at point E
represents the most utility. This is the highest attainable indifference curve with which you can get
OQ1 units of good X and OQ2 units of good Y for r 50. Any other affordable combinations on the price
line GH gives you less satisfaction, because that will be on a lower indifference curve IC1. With this we
conclude that the point of tangency between the budget line and an indifference curve represents
optimal consumption. It is the affordable combination that maximizes our utility.

34
At the tangency point E the slope of the price line GH and indifference curve are equal. Slope of the
indifference curve shows the marginal rate of substitution of X for Y. The price line indicates the ratio
between the prices of two goods (PX/PY). Thus at the equilibrium point E,MRSXY=Price of good x/Price
of good y= PX/PY

The tangency between the given price line and an indifference curve is a necessary but not a sufficient
condition consumer’s equilibrium .The second condition for consumer’s equilibrium is convexity of
indifference curve to the origin .Which means MRSxy is falling at the point of equilibrium.

In fig no -1 indifference curve IC2 is convex to the origin at point E, is the optimum or best choice for
the consumer .The consumer attains a stable equilibrium position where he is able to consume the
most preferred combination which gives him highest utility. In figure no -2 ,IC1 is concave to the origin
at point E. Price line AB is tangent to the indifference curve IC1 at point E and the marginal rate of
substitution of X for Y is equal to the price ratio of two goods (PX/PY). But E cannot be the position of
stable equilibrium because satisfaction would not be maximum .There are other combinations like G
and H in the given price line will be on higher indifference curve .The consumer by moving along the
given price line AB can go to other tangency point such as G and H and obtain greater satisfaction than
at point E.

Marginal Utility and Price

The slope of the indifference curve shows the marginal rate of substitution of good X for good Y, while
the slope of price line indicates the ratio between prices of two goods i.e. ( PX /PY). Consumer
equilibrium was represented as the combination of good X and good Y can be written as

Alternatively,

This equation explains that at the point of equilibrium the relative marginal utilities of good X and good
Y should equal to their relative prices. In other words , if good X cost twice as much as good Y , then
marginal utility of good X must yield double , then the consumer is in an optimal state.

The slope of the budget constraint equal the relative prices of the two goods. In Fig-1, the slope of the
price line equal to the price of goods X and good Y. It means the rate of substitution between the good
X and good Y is 1:2. The relative marginal utilities of the two goods are reflected in the slope of the
35
indifference curve. It is the marginal r ate of substitution which is equal to the relative marginal utilities
of the two goods.

At the point of optimal consumption E in fig-1 the budget constraint is tangent to the indifference curve
IC2. Which means?

Or Marginal rate of substitution of X for Y =

Consumer's Equilibrium and Non-normal cases

Indifference curves are usually convex to the origin .Convexity of indifference curve implies the
marginal rate of substitution of X for Y decreases .The possibility of concavity cannot be ruled out in
some exceptional cases. But at the same time concavity implies increasing marginal rate of
substitution of X for Y .The consumer will choose or buy only one good.

Fig No-3

The price line AB is tangent to the indifference curve IC2 . But the consumer cannot be in equilibrium
at point E because it can obtain grater satisfaction by moving along the given price line .Consumers
satisfaction increases by either moving upward or downward till he reaches the extremity points A on
the y-axis or B on the x –axis.

In these cases consumer will choose only one of two goods, depending on his scale of preference and
level of satisfaction between good x and good y. In the above diagram a lies on a higher indifference
curve than Therefore the consumer will choose only Y and buy OA of commodity Y. It is also noted that
consumer is not tangent to the indifference curve at point A .Therefore consumer’s equilibrium cannot
be establish at point A .

In case of perfect complementary goods ,the shape of the indifference curve have a right –angled .The
equilibrium of the consumer cannot be established because only one point of the indifference curve is
tangent to the price line AB.

36
Q.11 a) Explain the statement that “the shape of cost curves plays an important role in
decision making. (10)

Long run costs are accumulated when firms change production levels over time in response to
expected economic profits or losses. In the long run there are no fixed factors of production. The land,
labor, capital goods, and entrepreneurship all vary to reach the the long run cost of producing a good
or service. The long run is a planning and implementation stage for producers. They analyze the
current and projected state of the market in order to make production decisions. Efficient long run
costs are sustained when the combination of outputs that a firm produces results in the desired
quantity of the goods at the lowest possible cost. Examples of long run decisions that impact a firm's
costs include changing the quantity of production, decreasing or expanding a company, and entering or
leaving a market.
Short Run Costs

Short run costs are accumulated in real time throughout the production process. Fixed costs have no
impact of short run costs, only variable costs and revenues affect the short run production. Variable
costs change with the output. Examples of variable costs include employee wages and costs of raw
materials. The short run costs increase or decrease based on variable cost as well as the rate of
production. If a firm manages its short run costs well over time, it will be more likely to succeed in
reaching the desired long run costs and goals.
Differences

The main difference between long run and short run costs is that there are no fixed factors in the long
run; there are both fixed and variable factors in the short run . In the long run the general price level,
contractual wages, and expectations adjust fully to the state of the economy. In the short run these
variables do not always adjust due to the condensed time period. In order to be successful a firm must
set realistic long run cost expectations. How the short run costs are handled determines whether the
firm will meet its future production and financial goals.

37
Profit Maximization

In traditional economics, all firms seek to maximize profit - that is, the difference between total
revenue and total cost. To find the profit maximizing point, firms look at marginal revenue (MR) - the
total additional revenue from selling one additional unit of output - and the marginal cost (MC) - the
total additional cost of producing one additional unit of output. When the marginal revenue of selling a
good is greater than the marginal cost of producing it, firms are making a profit on that product. This
leads directly into the marginal decision rule: additional units of a good should be produced as long as
the marginal revenue of an additional unit exceeds the marginal cost. It follows that the maximizing
solution occurs where marginal revenue equals marginal cost.

This is relatively straightforward for firms in perfectly competitive markets, in which marginal revenue
is the same as price . Monopoly production, however, is complicated by the fact that monopolies have
demand curves and MR curves that are distinct, causing price to differ from marginal revenue .

Monopoly Profit Maximization

The marginal cost curves faced by monopolies are similar to those faced by perfectly competitive firms.
Most will have low marginal costs at low levels of production, reflecting the fact that firms can take
advantage of efficiency opportunities as they begin to grow. Marginal costs get higher as output
increases. For example, a pizza restaurant can easily double production from one pizza per hour to two
without hiring additional employees or buying more sophisticated equipment. When production reaches
50 pizzas per hour, however, it may be difficult to grow without investing a lot of money in more
skilled employees or more high-tech ovens. This trend is reflected in the upward-sloping portion of the
marginal cost curve.

The marginal revenue curve for monopolies, however, is quite different than the marginal revenue
curve for competitive firms. While competitive firms experience marginal revenue that is equal to price
- represented graphically by a horizontal line - monopolies have downward-sloping marginal revenue
curves that are different than the good's price.

To understand this, suppose a monopoly firm sells 2 units at a price of $8 per unit. Its total revenue is
$16. Now it wants to sell a third unit and wants to know the marginal revenue of that unit. To sell 3
units rather than 2, the firm must lower its price to $7 per unit. Total revenue rises to $21. The
marginal revenue of the third unit is thus $5. But the price at which the firm sells 3 units is $7.
Marginal revenue is less than price.

To see why the marginal revenue of the third unit is less than its price, we need to examine more
carefully how the sale of that unit affects the firm's revenues. The firm brings in $7 from the sale of the
third unit. But selling the third unit required the firm to charge a price of $7 instead of the $8 the firm

38
was charging for 2 units. Now the firm receives less for the first 2 units. The marginal revenue of the
third unit is the $7 the firm receives for that unit minus the $1 reduction in revenue for each of the
first two units. The marginal revenue of the third unit is thus $5. Marginal revenue is less than price.

Explaining the Law of Supply

There are three main reasons why supply curves are drawn as sloping upwards from left to right giving
a positive relationship between the market price and quantity supplied:

 The profit motive: When the market price rises following an increase in demand, it becomes
more profitable for businesses to increase their output
 Production and costs: When output expands, a firm's production costs tend to rise, therefore a
higher price is needed to cover these extra costs of production. This may be due to the effects
of diminishing returns as more factor inputs are added to production.
 New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in total supply.

b) With the help of expansion path derive long run total cost curve. (10

In the short run, because at least one factor of production is fixed, output can be increased only
by adding more variable factors. Hence we consider both fixed and variable costs

Fixed costs

Fixed costs are business expenses that do not vary directly with the level of output i.e. they are
treated as independent of the level of production.

Examples of fixed costs include the rental costs of buildings; the costs of leasing or purchasing capital
equipment such as plant and machinery; the annual business rate charged by local authorities; the
costs of full-time contracted salaried staff; the costs of meeting interest payments on loans; the
depreciation of fixed capital (due solely to age) and also the costs of business insurance.

Fixed costs are the overhead costs of a business. They are important in markets where the fixed
costs are high but the variable costs associated with making a small increase in output are relatively
low. We will come back to this when we consider economies of scale.

 Total fixed costs (TFC) remain constant as output increases

 Average fixed cost (AFC) = total fixed costs divided by output

Average fixed costs must fall continuously as output increases because total fixed costs are
being spread over a higher level of production. In industries where the ratio of fixed to variable costs is
extremely high, there is great scope for a business to exploit lower fixed costs per unit if it can produce

39
at a big enough size. Consider the new Sony portable play station. The fixed costs of developing the
product are enormous, but these costs can be divided by millions of individual units sold across the
world.

A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs!

Variable Costs

Variable costs are costs that vary directly with output. Examples of variable costs include the costs
of intermediate raw materials and other components, the wages of part-time staff or employees
paid by the hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and
tear. Average variable cost (AVC) = total variable costs (TVC) /output (Q)

Average Total Cost (ATC or AC)

Average total cost is simply the cost per unit produced

Average total cost (ATC) = total cost (TC) / output (Q)

Worked example of short run production costs

A simple numerical example of short run costs is shown in the table below. Fixed costs are assumed to
be constant at £200. Variable costs increase as more output is produced.

Total Fixed Total Variable Total Cost Average Cost Marginal Cost
Output Costs (TFC) Costs (TVC) Per Unit (the change in total cost
(Q) (TC= TFC + (AC = TC/Q) from a one unit change in
TVC) output)
0 200 0 200
50 200 100 300 6 2
100 200 180 400 4 2
150 200 230 450 3 1
200 200 260 460 2.3 0.2
250 200 280 465 1.86 0.1
300 200 290 480 1.6 0.3
350 200 325 525 1.5 0.9
400 200 400 600 1.5 1.5
450 200 610 810 1.8 4.2
500 200 750 1050 2.1 4.8

In our example, average cost per unit is minimised at a range of output between 350 and 400 units.
Thereafter, because the marginal cost of production exceeds the previous average, so the average cost
rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in
output has the effect of raising the cost per unit from 1.8 to 2.1).

Short Run Cost Curves

When diminishing returns set in (beyond output Q1) the marginal cost curve starts to rise. Average
total cost continues to fall until output Q2 where the rise in average variable cost equates with the fall
in average fixed cost. Output Q2 is the lowest point of the ATC curve for this business in the short run.
This is known as the output of productive efficiency.

40
A change in variable costs

A rise in the variable costs of production leads to an upward shift both in marginal and average total
cost. The firm is not able to supply as much output at the same price. The effect is that of an inward
shift in the supply curve of a business in a competitive market.

41
Analysis Diagram for External Economies of Scale (EEoS)

 External economies of scale occur outside of a firm but within an industry.

 For example investment in a better transportation network servicing an industry will
resulting in a decrease in costs for a company working within that industry.
 Another example is the development of research and development facilities in local
universities that several businesses in an area can benefit from.
 Likewise, the relocation of component suppliers and other support businesses close to the
centre of manufacturing are also an external cost saving.
 Agglomeration economies may also result from the clustering of businesses in a distinct
geographical location e.g. software in Silicon Valley or investment banks in the City of London

Economies of Scale – The Importance of Market Demand

The market structure of an industry is affected by the extent of economies of scale available to
individual suppliers and by the total size of market demand.

 In many industries, it is possible for smaller firms to make a profit because the cost
disadvantages they face are relatively small. Or because product differentiation allows a
business to charge a price premium to consumers which more than covers their higher costs.
 A good example is the retail market for furniture. The industry has major players in different
segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA. However,
much of the market is taken by smaller-scale suppliers with consumers willing to pay higher
prices for bespoke furniture owing to the low price elasticity of demand for high-quality,
hand crafted furniture products.
 Small-scale manufacturers can extract the consumer surplus that is present when demand is
estimated to have a low elasticity of demand.

Economies of Scope

 Economies of scope occur where it is cheaper to produce a range of products rather than
specialize in just a handful of products.

For example, in the competitive world of postal services and business logistics, service providers
such as Royal Mail, UK Mail, Deutsche Post and parcel carriers including TNT, UPS, and FedEx are
broadening the range of their services and making better use of their collection, sorting and
distribution networks to reduce costs and earn higher profits from higher-profit-margin and fast
growing markets.

 A company’s management structure, administration systems and marketing

departments are capable of carrying out these functions for more than one product.
 Expanding the product range to exploit the value of existing brands is a good way of
exploiting economies of scope.
 A good example of “brand extension” is the Easy Group under the control of Stelios where the
distinctive Easy Group business model has been applied (with varying degrees of success) to a
wide range of markets – easy Pizza, easy Cinema, easy Car rental, easy Bus and easy Hotel to
name just a handful!
 Procter and Gamble is the largest consumer household products maker in the world. Its brands
include Crest, Duracell, Gillette, Pantene, and Tide, to name just a few. Twenty four of its
brands make over $1 billion in sales annually.

Another example of an economy of scope might be a restaurant that has catering facilities and uses it
for multiple occasions – as a coffee shop during the day and as a supper-bar and jazz room in the
evenings.
A computing business can use its network and databases for many different uses.

Q.13 Explain how the long-run supply curve is derived in a increasing cost industry? (20)

The degree to which a market or industry can be described as competitive depends in part on how
many suppliers are seeking the demand of consumers and the ease with which new businesses can
enter and exit a particular market in the long run.

42
The spectrum of competition ranges from highly competitive markets where there are many sellers,
each of whom has little or no control over the market price - to a situation of pure monopoly where a
market or an industry is dominated by one single supplier who enjoys considerable discretion in setting
prices, unless subject to some form of direct regulation by the government.

In many sectors of the economy markets are best described by the term oligopoly - where a few
producers dominate the majority of the market and the industry is highly concentrated. In a duopoly
two firms dominate the market although there may be many smaller players in the industry.

Competitive markets operate on the basis of a number of assumptions. When these assumptions are
dropped - we move into the world of imperfect competition. These assumptions are discussed below

Assumptions behind a Perfectly Competitive Market

1. Many suppliers each with an insignificant share of the market – this means that each firm is too
small relative to the overall market to affect price via a change in its own supply – each individual firm
is assumed to be a price taker

2. An identical output produced by each firm – in other words, the market supplies homogeneous or
standardised products that are perfect substitutes for each other. Consumers perceive the products to
be identical

3. Consumers have perfect information about the prices all sellers in the market charge – so if some
firms decide to charge a price higher than the ruling market price, there will be a large substitution
effect away from this firm

4. All firms (industry participants and new entrants) are assumed to have equal access to resources
(technology, other factor inputs) and improvements in production technologies achieved by one firm
can spill-over to all the other suppliers in the market

5. There are assumed to be no barriers to entry & exit of firms in long run – which means that the
market is open to competition from new suppliers – this affects the long run profits made by each firm
in the industry. The long run equilibrium for a perfectly competitive market occurs when the marginal
firm makes normal profit only in the long term

6. No externalities in production and consumption so that there is no divergence between private and
social costs and benefits.

Existing firms

If most firms are making abnormal profits in the short run there will be an expansion of the output of
existing firms and we expect to see the entry of new firms into the industry. Firms are responding to
the profit motive and supernormal profits act as a signal for a reallocation of resources within the
market. The addition of new suppliers causes an outward shift in the market supply curve. This is
shown in the diagram below.

43
making the assumption that the market demand curve remains unchanged, higher market supply will
reduce the equilibrium market price until the price = long run average cost. At this point each firm is
making normal profits only. There is no further incentive for movement of firms in and out of the
industry and a long-run equilibrium has been established.

The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2.
At the profit-maximizing output level Q3 only normal profits are being made. There is no incentive for
firms to enter or leave the industry. Thus a long-run equilibrium is established.

Does perfect competition lead to economic efficiency?

Perfect competition is used as a yardstick to compare with other market structures (such a monopoly
and oligopoly) because it displays high levels of economic efficiency. In both the short and long run,
price is equal to marginal cost (P=MC) and therefore allocative efficiency is achieved – the price that
consumers are paying in the market reflects the factor cost of resources used up in producing /
providing the good or service.

Productive efficiency occurs when price is equal to average cost at its minimum point. This is not
achieved in the short run – firms can be operating at any point on their short run average total cost
curve, but productive efficiency is attained in the long run because the profit maximizing output is
achieved at a level where average (and marginal) revenue is tangential to the average total cost curve.
The long run of perfect competition, therefore, exhibits optimal levels of static economic efficiency.

There is of course another form of economic efficiency – dynamic efficiency – which relates to aspects
of market competition such as the rate of innovation in a market, the quality of output provided over
time.

'Discriminating Monopoly

A single entity that charges different prices, which are not associated with the cost to provide the
product or service, for its products or services for different consumers. A discriminating monopoly, by
using its monopolistic position, can do this as long as there are differences in price elasticity of demand
between consumers or markets, and barriers to prevent consumers from making an arbitrage profit by
selling among themselves. By catering to each type of customer the monopoly makes more profit.

An example is an airline monopoly. Airlines frequently sell various seats at various prices based on
demand. When a new flight is scheduled, airlines tend to lower the price of tickets to raise demand.
After enough tickets are sold, ticket prices increase and the airline tries to fill the remainder of the
flight at the higher price. Finally, when the date of the flight gets closer, the airline will once again
decrease the price of the tickets to fill the remaining seats. From a cost perspective, the breakeven

44
point of the flight is unchanged and the airline changes the price of the flight to increase and maximize
profits.

Q.14 Explain why you expect a monopoly firm to set a higher price and supply a lower
quantity, compared with an industry of purely competitive firm? (20)

Market equilibrium is the price at which demand equals supply. An equilibrium price exists if there is a
perfectly competitive market without any form of government intervention. The quantity demanded
and supplied at the equilibrium price are equal. However, shifts in any one of these three market
elements -- price, demand and supply -- may result in a change in the other two.

Supply and Demand Curves

Supply and demand curves are two-dimensional plots, with price on the vertical y-axis and quantity on
the horizontal x-axis. Aggregate supply-demand curves show the relationship between price and
quantity for all consumers and suppliers in the market. A demand curve slopes downward because
demand falls as the price increases. A supply curve slopes upward because supply increases with price.
The intersection of the supply and demand curves represents the market equilibrium price and
quantity.

Price

Consumers and businesses tend to purchase more when the market price is less than the equilibrium
price. This increases demand, which may cause shortages if suppliers are not willing to manufacture
additional quantities at the new lower price. Conversely, if the market price is higher than the
equilibrium price, more producers may be willing to supply at the higher price. However, fewer buyers
might be willing to buy at this higher price, thus resulting in a surplus.

Change in the market demand

Remaining competitive as a business in the marketplace is highly dependent on that business's ability
to supply consumers at or below the equilibrium price. Curiously, the business's ability to do so also
has an effect on the equilibrium price -- a business that can undercut the current market will see the
best demand, which may drive prices lower. Understanding how this equilibrium is determined is a
valuable lesson of basic economics.

Supply and Demand Curves

Economists use the idea of supply and demand curves to explain the behavior of markets. A supply
curve is a graphical representation of the ability to create, process and market goods and services. As
market prices increase, more producers are able to supply goods and services, which gives the supply
curve an upward slope. The demand curve works in opposite -- fewer consumers will purchase goods
and services as prices increase.

Equilibrium

Equilibrium is the price where the supply and demand curves intersect. It is believed that the market
will tend toward this price over the long-run, because it is the most efficient arrangement -- there are
no more consumers than there are products to supply to them, and no more producers than there are
consumers to buy from them. In an efficient market at equilibrium, producers create exactly as many
goods as consumers are able to buy, at exactly the price at which consumers can and wish to purchase
them.

Perfect Market Conditions

The assumption that supply and demand intersect in equilibrium is based on a hypothetical, perfectly
efficient and competitive market. In this conceptual framework, no producer and no consumer enjoys
price control over the market -- there are no monopolies. In addition, there are no barriers to entry or
exit from the market, and consumers and producers can choose to start or stop trading at any point
they choose. Consumers also have perfect knowledge of the products they're buying, and cannot be
defrauded into consuming more than would be efficient. Finally, a perfect market cannot have any
externalities -- costs or benefits not factored into the market price, such as pollution. While a perfect
45
market is a useful concept for understanding economics, it is important to remember that perfect
markets rarely, if ever, exist.

Deadweight Loss

In the real world, the conditions necessary for a perfectly efficient market producing an equilibrium do
not exist. Producers often enjoy near-monopoly control over the market, and can enforce a price floor
through barriers that prevent more efficient firms from entering the market. Taxes add a premium to
the costs of production, resulting in a lower quantity of demand than would be efficient without a tax.
In addition, producers and consumers create both positive and negative externalities through their
production and purchasing decisions. All of these situations create a degree of deadweight loss --
market value destroyed by consumption or production at greater or less than the efficient market
price. Changes in the many sources of deadweight loss result in changes to the market's real
equilibrium price.

The cost of production change

According to the economic model of supply and demand, supply refers to the quantity of a product that
suppliers can produce at a certain price. Demand represents the quantity of a product that consumers
are willing to purchase at a certain price. Supply curves usually have an upward slope, because
producers can sell more products if they are at higher prices. Demand curves slope downwards,
because people are willing to purchase more items when the price is lower. The intersection of the
demand and supply curves is the equilibrium price. Changes in supply or demand affect the equilibrium
price.

Increases in Demand

Consumer demand increases occur when consumers change their preferences. For example, an
effective advertising campaign or the results of a medical study on a certain food could change
consumer preferences. Demand also increases for most goods when consumer income increases, or if
substitute goods become more expensive. A change in population or demographics could also shift
demand. When demand increases, the curve shifts to the right, resulting in a higher equilibrium price.

Decreases in Demand

Decreases in consumer demand may occur when consumer income decreases. The demand for some
goods, called inferior goods, increases when income decreases, but a decrease in income usually
causes a decrease in demand. Changes in consumer preferences can also decrease demand. For
example, a study or news story about the dangers of a product could decrease demand. Decreases in
the price of substitute goods may also decrease demand, as could a loss in population or change in
demographics. When demand decreases, the curve shifts to the left, resulting in a lower equilibrium
price.

Increases in Supply

Increases in supply occur when technology improves, making production more efficient, or when labor
costs fall, making production less expensive. A decrease in the cost of input goods or resources also
increases supply. An increase in the supply curve shifts the curve to the right, resulting in a lower
equilibrium price.

Decreases in Supply

Decreases in supply occur when labor becomes more expensive or more scarce, driving up the cost of
production. A price increase or shortage of input goods or resources also decreases the quantity of
goods a firm can produce at a certain price. A decrease in the supply curve shifts the curve to the left,
resulting in a higher equilibrium price.

The taxes are imposed

A sales tax on a product, whether imposed by the federal government or by any other taxing authority,
has the effect of lessening the quantity of that product that potential buyers demand. This is portrayed

46
on supply-and-demand graphs as a move in the demand curve as it reflects the range of possible
pretax prices.

Supply

The law of supply and demand states that in conditions of free bargaining between buyers and sellers,
a commodity finds its equilibrium --- for both quantity sold and price --- where the quantity demanded
is equal to the quantity supplied. For purposes of this law, supply is understood as a schedule of the
various quantities that actual or potential merchants would bring to market at various possible prices.
This is often portrayed on a graph, where the vertical axis, or "y," represents the price, and the
horizontal axis, "x," represents the demand. Supply is a curve sloping upward to the right.

Demand

Likewise, for purposes of understanding the law of supply and demand as economists understand it,
demand is a schedule of the various quantities that actual or potential consumers will purchase at
various possible prices. Graphically, this is a curve sloping downward to the right. The equilibrium point
is the point at which the two lines intersect. Anything that moves either line while the other remains
constant changes the equilibrium point, and thus changes both the quantity purchased and the price.

Sales Tax

The simplest type of tax to represent in these terms is a sales tax. A buyer of a gallon of gasoline, for
example, may be indifferent regarding where his money is gong once he pays for that gallon. If he's
willing to pay up to $3.50 gallon, this is the case whether the gas is priced at $3.10 with a $0.40 sales
tax, or whether it's priced at $3.50 without any tax. If the tax component increases, so that the overall
price increases, the consumer demands the product less often. This by itself won't affect the supply
curve, so only the demand curve moves, producing a different point of equilibrium.

Employment

In the case of other sorts of taxation, the reasoning applied to sales taxes can be extended by analogy.
Consider the market for labor. Here the laborer is the one offering a supply to the market; actual or
potential employers make a demand on that market. Taxes, such as the Social Security tax --- half of
which falls on the employer/buyer --- act much as a sales tax does: They make the productivity of
each potential new employee --- or each new hour of work that might be performed by an existing
employee willing to work overtime --- less productive or profitable for the employer than it would
otherwise have been, which depresses the whole demand curve for labor.

Q.15 What is “excess capacity”? Why is excess capacity to be expected in the long-run
equilibriums of a monopolistically competitive firm? (20)

Edward Hastings Chamberlin (b. 1899) in 1933 published The Theory of Monopolistic Competition as a
reorientation of the theory of value, designed to base it on a synthesis of monopolistic and competitive
theories. He argues that the old idea of monopoly and competition as alternative is wrong; and that
most situations are composites in which elements of both monopoly and competition are combined. But
he asserts that the correct procedure is to start from the theory of monopoly. This, he thinks, has the
merit of eliminating none of the competitive elements, since these operate through the demand for the
monopolist's product; while on the contrary the alternative assumption of competition rules out the
monopoly elements.

Thus, in taking monopoly as a starting point, Chamberlin's approach is similar to that of Cournot.

But, while with Cournot the transition to perfect competition takes place only on a scale of numbers of
competitors, with Chamberlin it takes place also on a scale of substitution of products. Any producer
whose product is significantly different from the products of others has some monopoly of it, subject to
the competition of substitutes. He considers each producer in an industry as having some monopoly in
his own product. If he be the sole seller of a unique product, he has a pure monopoly.1 If there be two
sellers of similar products, the situation is one of "duopoly." If there be several, an "oligopoly" exists.
The condition may range through various degrees of oligopoly to pure competition, under which there
are so many sellers of a highly standardized product that any one could sell all his product without
affecting the demand. Pure competition is found only under the dual condition of (a) a large number,
47
and (b) a perfectly standardized product. The usual condition Chamberlin considers to be in the
intermediate area, in which some element of "monopoly" exists, and which he calls "monopolistic
competition."

Economic inertia and friction are "imperfections" which he does not consider as part of "monopolistic
competition."

Thus Chamberlin's thought centers on the product. Each producer, under "monopolistic competition,"
faces competition from "substitute" products which are not identical and which are sold by other
concerns with various price policies, and sales expenses. These merely limit his "monopoly" of his own
product.

Individual demand curve

The individual demand curve (or sales) for one seller's product is then regarded as affected by the
market policies of other individual sellers whose products are partial substitutes. Total sales of the
partly competing group of substitute products are treated as limiting the sales of the product of any
one seller. Under "pure" competition (many sellers and a completely standardized product) a horizontal
demand curve (average revenue) would exist for each individual competitor's product. This would
mean identical prices. Chamberlin argues that "pure" competition would force all individual competitors
to treat differential advantages, or rents, as costs, the same as other costs.

Chamberlin emphasizes the effect of judgments by one seller concerning his rivals' policies, possible
retaliation, etc. He also argues that selling costs such as advertising are not part of the cost of
production, but are incurred to increase the sales of the given product; and thus they affect the
demand curve. Throughout, his basic idea is that, no matter how slight, any differentiation of a seller's
product gives him to that extent a monopoly. And all these conditions, commonly found in competitive
markets, are either "impurities" in the nature of monopoly elements, or are associated with such
elements. They make "pure" competition impossible.

To Chamberlin, actual "competition"1 includes the effort of competitors to increase their monopoly
powers.

DD’= demand curve (avg. rev.)

PP’= avg. cost of production, including a "minimum profit" (charge required to attract capital and
enterprise) and all "rents"
FF’= avg. total cost, including fixed uniform selling costs
AR= price
EHRR’= profit (above "minimum")
OA= quantity sold
pp’= marginal cost of production
dd’= marginal revenue
Q= intersection of pp' and dd'

48
And the essence of "monopoly," and therefore of "monopolistic competition," is seen as lying in
differences — (1) differences in price policy, (2) differences in nature of product, and (3) differences in
such sales effort as advertising outlays. It is a contribution of Chamberlin's to have developed the
second and third of these variables as arising out of the mixture of monopoly and competition.

Chamberlin starts with a single firm and develops the idea of monopoly price and competitive prices as
determined by the intersection of revenue or sales curves with expense curves. Either the marginal
revenue curve, or the average revenue curve (from which it is derived), may be used to determine the
monopoly output and price, the former by intersecting the rising marginal cost curve, the latter by the
familiar Marshallian method of fitting the maximum profit area between it and the average cost curve,
which includes rents or differentials and thus equals the average price.

Three variables

The analysis with respect to all three variables then is extended beyond the firm to groups of sellers,
which may be taken as corresponding to conventional "industries," depending on how broadly a "class
of product" is conceived in a particular case. The group is analyzed, first under the assumption of
symmetry (all its members assumed to have uniform cost and demand curves). Then some
consideration is given to what might happen if a "diversity of conditions" existed. If selling costs are
not great, and if they reduce the slope of the sellers' demand curves, increasing them may result in a
lower price. Variations in product may lead to either smaller or larger outputs. Group equilibrium (with
"alert" competitors) must result in the optimum with respect to all the variables, and no profits above a
necessary minimum for every producer.

The conclusion is drawn that under monopolistic competition the equilibrium price is higher, and the
volume of output probably (not necessarily) lower, than under pure competition. The net profits of
enterprise, however, may or may not be higher than under pure competition because of the expense
which is required to maintain the monopoly elements and which is often increased by a multiplication
of substitute products surrounding the monopolist. Chamberlin argues that monopolistic competition
need not bring higher profits to the marginal firm in a given industry. Instead it may allow the
existence of a larger number of firms making normal profits.

Q.16 Using the kinked demand curve model explain how a reduction in costs might lead to
no change in price or output? Does profit increase? If so why are new firm not induced to
enter the market? (20)

As mentioned above, there is no single theory of oligopoly. The two that are most frequently discussed,
however, are the kinked demand theory and the cartel theory. The kinked demand theory is
illustrated in Figure and applies to oligopolistic markets where each firm sells a differentiated
product. According to the kinked demand theory, each firm will face two market demand curves for
its product. At high prices, the firm faces the relatively elastic market demand curve, labeled MD 1 in
Figure .

49
Corresponding to MD 1 is the marginal revenue curve labeled MR 1. At low prices, the firm faces the
relatively inelastic market demand curve labeled MD 2. Corresponding to MD 2 is the marginal revenue
curve labeled MR 2.

The two market demand curves intersect at point b. Therefore, the market demand curve that the
oligopolist actually faces is the kinked demand curve, labeled abc. Similarly, the marginal revenue
that the oligopolist actually receives is represented by the marginal revenue curve labeled adef. The
oligopolist maximizes profits by equating marginal revenue with marginal cost, which results in an
equilibrium output of Q units and an equilibrium price of P.

The oligopolist faces a kinked demand curve because of competition from other oligopolists in the
market. If the oligopolist increases its price above the equilibrium price P, it is assumed that the other
oligopolists in the market will not follow with price increases of their own. The oligopolist will then face
the more elastic market demand curve MD 1.

The oligopolist's market demand curve becomes more elastic at prices above P because at these higher
prices consumers are more likely to switch to the lower priced products provided by the other
oligopolists in the market. Consequently, the demand for the oligopolist's output falls off more quickly
at prices above P; in other words, the demand for the oligopolist's output becomes more elastic.

Oligopolist’s market demand curve

If the oligopolist reduces its price below P, it is assumed that its competitors will follow suit and reduce
their prices as well. The oligopolist will then face the relatively less elastic (or more inelastic) market
demand curve MD 2. The oligopolist's market demand curve becomes less elastic at prices below P
because the other oligopolists in the market have also reduced their prices. When oligopolists follow
each others pricing decisions, consumer demand for each oligopolist's product will become less elastic
(or less sensitive) to changes in price because each oligopolist is matching the price changes of its
competitors.

The kinked demand theory of oligopoly illustrates the high degree of interdependence that exists
among the firms that make up an oligopoly. The market demand curve that each oligopolist faces is

50
determined by the output and price decisions of the other firms in the oligopoly; this is the major
contribution of the kinked demand theory.

The kinked demand theory, however, is considered an incomplete theory of oligopoly for several
reasons. First, it does not explain how the oligopolist finds the kinked point in its market demand
curve. Second, the kinked demand theory does not allow for the possibility that price increases by one
oligopolist are matched by other oligopolists, a practice that has been frequently observed. Finally, the
kinked demand theory does not consider the possibility that oligopolists collude in setting output and
price. The possibility of collusive behavior is captured in the alternative theory known as the cartel
theory of oligopoly.

The assumption is that firms in an oligopoly are looking to protect and maintain their market share
and that rival firms are unlikely to match another's price increase but may match a price fall.
I.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm.

If a business raises price and others leave their prices constant, then we can expect quite a large
substitution effect making demand relatively price elastic. The business would then lose market
share and expect to see a fall in its total revenue.

If a business reduces its price but other firms follow suit, the relative price change is smaller and
demand would be inelastic. Cutting prices when demand is inelastic leads to a fall in revenue with little
or no effect on market share.

Analysis diagram of the kinked demand curve

The kinked demand curve model makes a prediction that a business might reach a stable profit-
maximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.

 The kinked demand curve model predicts there will be periods of relative price stability
under an oligopoly with businesses focusing on non-price competition as a means of
reinforcing their market position and increasing their supernormal profits.

 Short-lived price wars between rival firms can still happen under the kinked demand curve
model. During a price war, firms in the market are seeking to snatch a short term advantage
and win over some extra market share.

Recent examples of price wars include the major UK supermarkets, price discounting of computers in
China and a price war between cross channel speed ferry services. Price competition is frequently seen
in the telecommunications industry.

51
Changes in costs using the kinked demand curve analysis

One prediction of the kinked demand curve model is that changes in variable costs might not lead to a
rise or fall in the profit maximising price and output. This is shown in the next diagram where it is
assumed that a rise in costs such as energy and raw material prices leads to an upward shift in the
marginal cost curve from MC1 to MC2. Despite this shift, the equilibrium price and output remains at
Q1. It would take another hike in costs to MC3 for the price to alter.

Changes in marginal cost

There is limited real-world evidence for the kinked demand curve model. The theory can be
criticised for not explaining why firms start out at the equilibrium price and quantity. That said it is one
possible model of how firms in an oligopoly might behave if they have to consider the responses of
their rivals.

Q.17 What do you know about the direct and indirect effects of the decision taken by the
firms? Explain your answer in the light of Chamberlin’s oligopoly model. (20)

An economic impact analysis (EIA) examines the effect of an event on the economy in a specified area,
ranging from a single neighborhood to the entire globe. It usually measures changes in business
revenue, business profits, personal wages, and/or jobs. The economic event analyzed can include
implementation of a new policy or project, or may simply be the presence of a business or
organization. An economic impact analysis is commonly conducted when there is public concern about
the potential impacts of a proposed project or policy. An economic impact analysis typically measures
or estimates the change in economic activity between two scenarios, one assuming the economic event
occurs, and one assuming it does not occur (which is referred to as the counterfactual case). This can
be accomplished either before or after the event (ex ante or ex post).

Sources of Economic Impacts

In addition to the types of impacts, economic impact analyses often estimate the sources of the
impacts. Each impact can be decomposed into different components, depending on the effect that
caused the impact. Direct effects are the results of the money initially spent in the study region by the
business or organization being studied. This includes money spent to pay for salaries, supplies, raw
materials, and operating expenses.

The direct effects from the initial spending creates additional activity in the local economy. Indirect
effects are the results of business-to-business transactions indirectly caused by the direct effects.
Businesses initially benefiting from the direct effects will subsequently increase spending at other local
52
businesses. The indirect effect is a measure of this increase in business-to-business activity (not
including the initial round of spending, which is included in the direct effects).

Induced effects are the results of increased personal income caused by the direct and indirect effects.
Businesses experiencing increased revenue from the direct and indirect effects will subsequently
increase payroll expenditures (by hiring more employees, increasing payroll hours, raising salaries,
etc.). Households will, in turn, increase spending at local businesses. The induced effect is a measure
of this increase in household-to-business activity. Finally, dynamic effects are caused by geographic
shifts over time in populations and businesses.

Comparison to Other Analyses

Economic impact analyses are related to but differ from other similar studies. An economic impact
analysis only covers specific types of economic activity. Some social impacts that affect a region's
quality of life, such as safety and pollution, may be analyzed as part of a social impact assessment, but
not an economic impact analysis, even if the economic value of those factors could be quantified. An
economic impact analysis may be performed as one part of a broader environmental impact
assessment, which is often used to examine impacts of proposed development projects. An economic
impact analysis may also be performed to help calculate the benefits as part of a cost-benefit analysis.

Chamberlin’s oligopoly model

Chamberlin’s contribution to the theory of oligopoly consists in his suggestion that a stable equilibrium
can be reached with the monopoly price being charged by all firms, if firms recognize their
interdependence and act so as to maximize the industry profit (monopoly profit).

Chamberlin accepts that if firms do not recognize their interdependence, the industry will reach either
the Cournot equilibrium. If each firm acts independently on the assumption that the rivals will keep
their output constant; or the industry will reach the Bertrand equilibrium if each firm acts
independently, trying to maximize its own profit on the assumption that the other rivals will keep their
price unchanged.

Chamberlin, however, rejects the assumption of independent action by competitors. He says that the
firms do in fact recognize their interdependence. Firms are not as naive as Cournot and Bertrand
assume. Firms, when changing their price or output, recognize the direct and indirect effects of their
decisions. The direct effects are those which would occur if competitors were assumed to remain
passive (either in the Cournot or in the Bertrand sense).

The indirect effects are those which result from the fact that rivals do not in fact remain passive but
react to the decisions of the firm which changes its price or output. The recognition of the full effects
(direct and indirect) of a change in the firm’s output (or price) results in a stable industry equilibrium
with the monopoly price and monopoly output.

Chamberlin assumes that the monopoly solution (with industry or joint profits being maximized) can be
achieved without collusion the entrepreneurs are assumed to be intelligent enough to quickly recognize
their interdependence, learn from their past mistakes and adopt the best (for all) position, which is
charging the monopoly price.

Chamberlin’s model can best be understood if presented in a duopoly market. Initially Chamberlin’s
model is the same as Cournot’s. The market demand is a straight line with negative slope, and
production is assumed costless for simplicity (figure 9.15). If firm A is the first to start production it will
produce the profit-maximizing output 0X M and sell it at the monopoly price.

53
Firm B, under the Cournot assumption that the rival A will retain his quantity unchanged, considers
that its demand curve is CD and will attempt to maximize its profit by producing one-half of this
demand, that is, quantity XMB (at which B’s MR = MC = 0). As a consequence the total industry output
is OB and the price falls to P. Now firm A realizes that its rival does in fact react to its actions, and
taking that into account decides to reduce its output to 0A which is one-half of 0XM and equal to B’s
output.

The industry output is thus 0XM and price rises to the monopoly level 0PM. Firm B realizes that this is
the best for both of them and so will keep its output the same at XMB = AXM. Thus, by recognizing their
interdependence the firms reach the monopoly solution. Under the assumption of our example of equal
costs (that is, costs = 0) the market will be shared equally between A and B (clearly 0A = AXM).
Chamberlin’s model is an advance over the previous models in that it assumes that the firms are
sophisticated enough to realise their interdependence, and that it leads to a stable equilibrium, which is
the monopoly solution.

However, joint profit maximisation via non-collusive action implies that firms have a good knowledge of
the market-demand curve and that they soon realise their mistakes. That is, they somehow acquire a
knowledge of the total-supply curve (i.e. of the individual costs of the rivals) and hence they define the
(monopoly) price which is best for the group as a whole. Without collusion joint profit maximisation is
impossible unless all firms have identical costs and demands.

Chamberlin’s small group model suffers also from the defect of ignoring entry. It is a ‘closed’ model. If
entry does occur it is not certain that the stable monopoly solution will ever be reached, unless special
assumptions are made concerning the behaviour of the old firms and the new entrant.

It should be noted that although the ‘kinked-demand curve’ appears in Chamberlin’s analysis (of both
the ‘large group’ and the ‘small group’), he does not use it explicitly as a tool of analysis of the
behaviour of the firm. The ‘kinked-demand curve model’ as an operational oligopoly model was
presented by P. Sweezy in 1939. We turn to the examination of this model.

Q.18 Write notes on the following: (20)

i) Collusive Oligopoly

Oligopoly is a market structure in which there are a few firms producing a product. When there are few
firms in the market, they may collude to set a price or output level for the market in order to maximize
industry profits . As a result, price will be higher than the market-clearing price, and output is likely to
be lower. At the extreme, the colluding firms may act as a monopoly, reducing their individual output
so that their collective output would equal that of a monopolist, allowing them to earn higher profits.

If oligopolists individually pursued their own self-interest, then they would produce a total quantity
greater than the monopoly quantity, and charge a lower price than the monopoly price, thus earning a
smaller profit. The promise of bigger profits gives oligopolists an incentive to cooperate. However,
collusive oligopoly is inherently unstable, because the most efficient firms will be tempted to break
ranks by cutting prices in order to increase market share.

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Several factors deter collusion. First, price-fixing is illegal in the United States, and antitrust laws exist
to prevent collusion between firms. Second, coordination among firms is difficult, and becomes more
so the greater the number of firms involved. Third, there is a threat of defection. A firm may agree to
collude and then break the agreement, undercutting the profits of the firms still holding to the
agreement. Finally, a firm may be discouraged from collusion if it does not perceive itself to be able to
effectively punish firms that may break the agreement.

In contrast to price-fixing, price leadership is a type of informal collusion which is generally legal. Price
leadership, which is also sometimes called parallel pricing, occurs when the dominant competitor
publishes its price ahead of other firms in the market, and the other firms then match the announced
price. The leader will typically set the price to maximize its profits, which may not be the price that
maximized other firms' profits.

Collusion is an agreement between two or more parties, sometimes illegal and therefore secretive, to
limit open competition by deceiving, misleading, or defrauding others of their legal rights, or to obtain
an objective forbidden by law typically by defrauding or gaining an unfair market advantage. It is an
agreement among firms or individuals to divide a market, set prices, limit production or limit
opportunities. It can involve "wage fixing, kickbacks, or misrepresenting the independence of the
relationship between the colluding parties".[2] In legal terms, all acts effected by collusion are
considered void.

Variations

According to neoclassical price-determination theory and game theory, the independence of suppliers
forces prices to their minimum, increasing efficiency and decreasing the price determining ability of
each individual firm.[citation needed] However, if firms collude to all increase prices, loss of sales is
minimized, as consumers lack alternative choices at lower prices. This benefits the colluding firms at
the cost of efficiency to society.

One variation of this traditional theory is the theory of kinked demand. Firms face a kinked demand
curve if, when one firm decreases its price, other firms will follow suit in order to maintain sales, and
when one firm increases its price, its rivals are unlikely to follow, as they would lose the sales' gains
that they would otherwise get by holding prices at the previous level. Kinked demand potentially
fosters supra-competitive prices because any one firm would receive a reduced benefit from cutting
price, as opposed to the benefits accruing under neoclassical theory and certain game theoretic models
such as Bertrand competition.

Examples

Collusion is largely illegal in the United States, Canada and most of the EU due to competition/antitrust
law, but implicit collusion in the form of price leadership and tacit understandings still takes place.
Several examples of collusion in the United States include:

Market division and price-fixing among manufacturers of heavy electrical equipment in the 1960s,
including General Electric.

An attempt by Major League Baseball owners to restrict players' salaries in the mid-1980s.
The sharing of potential contract terms by NBA free agents in an effort to help a targeted franchise
circumvent the salary cap Price fixing within food manufacturers providing cafeteria food to schools and
the military in 1993. Market division and output determination of livestock feed additive, called lysine,
by companies in the US, Japan and South Korea in 1996, Archer Daniels Midland being the most
notable of these.

Chip dumping in poker or any other high stake card game.

There are many ways that implicit collusion tends to develop:

The practice of stock analyst conference calls and meetings of industry participants almost necessarily
results in tremendous amounts of strategic and price transparency. This allows each firm to see how
and why every other firm is pricing their products.

If the practice of the industry causes more complicated pricing, which is hard for the consumer to
understand (such as risk-based pricing, hidden taxes and fees in the wireless industry, negotiable
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pricing), this can cause competition based on price to be meaningless (because it would be too
complicated to explain to the customer in a short advertisement). This causes industries to have
essentially the same prices and compete on advertising and image, something theoretically as
damaging to consumers as normal price fixing.

Barriers

There can be significant barriers to collusion. In any given industry, these may include:

The number of firms: As the number of firms in an industry increases, it is more difficult to
successfully organize, collude and communicate.

Cost and demand differences between firms: If costs vary significantly between firms, it may be
impossible to establish a price at which to fix output.

Cheating: There is considerable incentive to cheat on collusion agreements; although lowering prices
might trigger price wars, in the short term the defecting firm may gain considerably. This phenomenon
is frequently referred to as "chiseling".

Potential entry: New firms may enter the industry, establishing a new baseline price and eliminating
collusion (though anti-dumping laws and tariffs can prevent foreign companies entering the market).

Economic recession: An increase in average total cost or a decrease in revenue provides incentive to
compete with rival firms in order to secure a larger market share and increased demand.

Anticollusion legal framework and collusive lawsuit.

ii) Multiplant Monopoly

Here we will discuss about a monopolist, who produces a homogenous product in two or more different
plants with different cost conditions. It is referred to as a case of Multiplan monopoly. To maximise
profits, the monopolist has to make two important decisions. Firstly, how much output to produce
altogether and at what price to sell it so as to maximise profit? Secondly, how to allocate the optimal
(profit maximising) output between the different plants?

Thus, the Multiplan monopolist not only faces the problem of determining the profit maximising price
and output levels. He has also to decide a profit maximising way for distributing this output among the
various plants, which in turn depends upon the cost conditions prevailing in each plant.

If the marginal cost of production in any plant is lower than that in the others, then it costs relatively
less to produce an additional unit of output in this plant in comparison to the other plants. The
concerned monopolist can reduce his total costs and hence raise his profit level by diverting production
from other higher cost plants to that specific plant.

Ultimately, the cost minimising or profit maximising allocation of total output among different plants of
a Multiplan monopolist can be achieved, when the marginal cost of production is equated across all the
plants. Now, no more further redistribution of output from one plant to the other can reduce the overall
costs of production.

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As far as the determination of the profit maximising output level is concerned, the Multiplan monopolist
(just like an ordinary monopolist or any profit maximising firm) applies the marginalist rule of the
equality of marginal revenue (MR) and (total) marginal cost (MC) in the market. This is described
below in case of a monopolist operating with two plants. It can easily be generalised to any number of
plants.

Assume that the monopolist operates two plants ‘A’ and ‘B’ each with a different cost structure as
shown in Fig. 14.9 (a) and Fig. 14.9 (b) respectively. ACA and ACB represent the average cost curves of
plant ‘A’ and plant ‘B’ respectively.

Their corresponding marginal cost curves MCA and MCB intersect the average cost curves ACA and
ACB from below at their respective minimum points. The total marginal cost (MC) curve of the Multiplan
monopolist can simply be derived from the horizontal summation of the marginal cost curves (MCA and
MCB) of the individual plants (Fig. 14.9 (c)). The monopolist is supposed to know the cost structures of
the different plants besides the market demand or average revenue curve AR (and the corresponding
marginal revenue curve MR).

Given the MR and MC curves, the profit maximising total output will be OQ corresponding to the
equilibrium point ‘E’ in Fig. 14.9 (c), where the MR curve intersects the (aggregate) MC curve from
below. The firm will sell this output at equilibrium price OP.

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The Multiplan monopolist attains maximum profits at equilibrium point ‘E’. The monopolist is now
confronted with the problem of allocating the profit maximising output OQ between the two plants in
an optimal manner. He will allocate this output in a way such that marginal cost of each plant is equal
to the Multiplan marginal cost at the optimal output level, i.e. MCA = MCB = MC.

If MCA > MCB, the monopolist can reduce his total costs and increase the profits by transferring the
output from plant ‘A’ to plant ‘B’ similarly if MCA, < MCB, the output would be transferred from plant
‘B’ to plant ‘A’. This process of transfer would continue until MCA = MCB.

Graphically, this can be shown by drawing a horizontal line from equilibrium point ‘E’ in Fig. 14.9 (c),
parallel to the X-axis, until it intersects the MCA and MCB curves in Fig. 14.9 (a) and Fig. 14.9 (b) at
points EA and E0 respectively. At these points, the equilibrium condition MCA = MC0 = MR = MC is
satisfied. This is the condition required for efficient allocation of the profit maximising output of the
Multiplan monopolist among the two industrial plants ‘A’ and ‘B’.

The output levels corresponding to the equilibrium points ‘EA‘ and ‘EB‘ are obtained by dropping
perpendiculars to X-axis of Fig. 14.9 (a) and Fig, 14.9 (b) respectively. Out of the total output OQ to
be produced by the monopolist under consideration, OQA will be produced in plant ‘A’ and OQB will be
produced in plant ‘B’.

Evidently, OQA + OQB = OQ, since the aggregate marginal cost curve MC in Fig 14.9 (c) was itself
obtained from the horizontal summation of the individual marginal cost curves MCA and MCB, as
depicted in Fig. 14.9 (a) and Fig. 14.9 (b) respectively.

The profits from the two plants ‘A’ and ‘B’ are shown by the shaded areas DPBC and HPFG respectively.
The total profit earned by the monopolist at the equilibrium point ‘E’ is shown by the shaded area JIE in
Fig. 14.9 (c), which is equal to the sum of the profits earned in plant ‘A’ and plant ‘B’, i.e., area
(DPBC+ HPFG).

From the foregoing discussion, it can be inferred that the Multiplan monopolist maximises his profits
and attains equilibrium by utilising each plant up to the level at which the marginal costs are equal to
each other and to the common marginal revenue and total marginal cost in the market.

Q.19 Give details of Cournot model with the help of reaction approach showing those how
two firms attain stable equilibrium. (20)

Cournot competition is an economic model used to describe an industry structure in which

companies compete on the amount of output they will produce, which they decide on independently of
each other and at the same time. It is named after Antoine Augustin Cournot[1] (1801–1877) who was
inspired by observing competition in a spring water duopoly. It has the following features:

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 There is more than one firm and all firms produce a homogeneous product, i.e. there is
no product differentiation;
 Firms do not cooperate, i.e. there is no collusion;
 Firms have market power, i.e. each firm's output decision affects the good's price;
 The number of firms is fixed;
 Firms compete in quantities, and choose quantities simultaneously;
 The firms are economically rational and act strategically, usually seeking to maximize profit
given their competitors' decisions.
An essential assumption of this model is the "not conjecture" that each firm aims to maximize profits,
based on the expectation that its own output decision will not have an effect on the decisions of its
rivals. Price is a commonly known decreasing function of total output. All firms know , the total
number of firms in the market, and take the output of the others as given. Each firm has a cost
function . Normally the cost functions are treated as common knowledge. The cost functions may
be the same or different among firms. The market price is set at a level such that demand equals the
total quantity produced by all firms. Each firm takes the quantity set by its competitors as a given,
evaluates its residual demand, and then behaves as a monopoly.
Theory of competition

First outlined his theory of competition in his 1838 volume Recherches sur les Principes Mathematiques
de la Theorie des Richesses as a way of describing the competition with a market for spring water
dominated by two suppliers (a duopoly). The model was one of a number that Cournot set out
"explicitly and with mathematical precision" in the volume. Specifically, Cournot constructed profit
functions for each firm, and then used partial differentiation to construct a function representing a
firm's best response for given (exogenous) output levels of the other firm(s) in the market.[3] He then
showed that a stable equilibrium occurs where these functions intersect (i.e. the simultaneous solution
of the best response functions of each firm).

The consequence of this is that in equilibrium, each firm's expectations of how other firms will act are
shown to be correct; when all is revealed, no firm wants to change its output decision.[1] This idea of
stability was later taken up and built upon as a description of Nash equilibria, of which Cournot
equilibria are a subset.

Graphically finding the Cournot duopoly equilibrium[edit]

This section presents an analysis of the model with 2 firms and constant marginal cost.
= firm 1 price, = firm 2 price
= firm 1 quantity, = firm 2 quantity
= marginal cost, identical for both firms
Equilibrium prices will be:

This implies that firm 1’s profit is given by

Calculate firm 1’s residual demand: Suppose firm 1 believes firm 2 is producing quantity . What is
firm 1's optimal quantity? Consider the diagram 1. If firm 1 decides not to produce anything, then price
is given by . If firm 1 produces then price is given by . More
generally, for each quantity that firm 1 might decide to set, price is given by the curve . The
curve is called firm 1’s residual demand; it gives all possible combinations of firm 1’s quantity
and price for a given value of .

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Determine firm 1’s optimum output: To do this we must find where marginal revenue equals marginal
cost. Marginal cost (c) is assumed to be constant. Marginal revenue is a curve - - with twice the
slope of and with the same vertical intercept. The point at which the two curves ( and )
intersect corresponds to quantity . Firm 1’s optimum , depends on what it believes firm 2
is doing. To find an equilibrium, we derive firm 1’s optimum for other possible values of . Diagram 2
considers two possible values of . If , then the first firm's residual demand is effectively the
market demand, . The optimal solution is for firm 1 to choose
the monopoly quantity; ( is monopoly quantity). If firm 2 were to choose the quantity
corresponding to perfect competition, such that , then firm 1’s optimum would be
to produce nil: . This is the point at which marginal cost intercepts the marginal revenue
corresponding to .

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It can be shown that, given the linear demand and constant marginal cost, the function is also
linear. Because we have two points, we can draw the entire function , see diagram 3. Note the
axis of the graphs has changed, The function is firm 1’s reaction function, it gives firm 1’s
optimal choice for each possible choice by firm 2. In other words, it gives firm 1’s choice given what it
believes firm 2 is doing.

The last stage in finding the Cournot equilibrium is to find firm 2’s reaction function. In this case it is
symmetrical to firm 1’s as they have the same cost function. The equilibrium is the intersection point of
the reaction curves. See diagram 4.
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The prediction of the model is that the firms will choose Nash equilibrium output levels.

Calculating the equilibrium

In very general terms, let the price function for the (duopoly) industry be and firm i have
the cost structure . To calculate the Nash equilibrium, the best response functions of the firms
must first be calculated. The profit of firm i is revenue minus cost. Revenue is the product of price and
quantity and cost is given by the firm's cost function, so profit is (as described
above): . The best response is to find the value of that
maximises given , with , i.e. given some output of the opponent firm, the output that
maximises profit is found. Hence, the maximum of with respect to is to be found. First take the
derivative of with respect to :

Setting this to zero for maximization:

The values of that satisfy this equation are the best responses. The Nash equilibria are where
both and are best responses given those values of and .
An example

Suppose the industry has the following price structure: The profit of

firm i (with cost structure such that and for ease of

computation) is:

The maximization problem resolves to (from the general case):

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 Without loss of generality, consider firm 1's problem:

By symmetry:

These are the firms' best response functions. For any value of , firm 1 responds best with any value
of that satisfies the above. In Nash equilibria, both firms will be playing best responses so solving
the above equations simultaneously. Substituting for in firm 1's best response:

The symmetric Nash equilibrium is at . (See Holt (2005, Chapter 13) for asymmetric
examples.) Making suitable assumptions for the partial derivatives (for example, assuming each firm's
cost is a linear function of quantity and thus using the slope of that function in the calculation), the
equilibrium quantities can be substituted in the assumed industry price
structure to obtain the equilibrium market price.

Cournot competition with many firms and the Cournot theorem

For an arbitrary number of firms, N > 1, the quantities and price can be derived in a manner analogous
to that given above. With linear demand and identical, constant marginal cost the equilibrium values
are as follows:

Market demand;

Cost function; , for all i

which is each individual firm's output

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which is total industry output

which is the market clearing price, and

, which is each individual firm's profit.

The Cournot Theorem then states that, in absence of fixed costs of production, as the number of firms
in the market, N, goes to infinity, market output, Nq, goes to the competitive level and the price
converges to marginal cost.

Hence with many firms a Cournot market approximates a perfectly competitive market. This result can
be generalized to the case of firms with different cost structures (under appropriate restrictions) and
non-linear demand.
When the market is characterized by fixed costs of production, however, we can endogenize the
number of competitors imagining that firms enter in the market until their profits are zero. In our
linear example with firms, when fixed costs for each firm are , we have the endogenous number
of firms:

and a production for each firm equal to:

This equilibrium is usually known as Cournot equilibrium with endogenous entry, or Marshall
equilibrium.

Implications

Output is greater with Cournot duopoly than monopoly, but lower than perfect competition.

Price is lower with Cournot duopoly than monopoly, but not as low as with perfect competition.

According to this model the firms have an incentive to form a cartel, effectively turning the Cournot
model into a Monopoly. Cartels are usually illegal, so firms might instead tacitly collude using self-
imposing strategies to reduce output which, ceteris paribus will raise the price and thus increase profits
for all firms involved.

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